Subir Gokarn: The whole and the parts

The RBI must have thought the costs of resisting pressure on the rupee to appreciate would outweigh the benefits.

Since the rupee began to appreciate towards the end of March, there has been much concern voiced over the impact of this movement on exports and exporters. This concern culminated last week in the announcement of some fiscal and interest rate measures to counteract the effects of appreciation on exporters. Whether they will or not is a separate discussion. The point that motivates this article is that the appreciation of the rupee is being attributed to the way in which monetary policy is being conducted. The nexus between monetary policy and exports introduces a "political economy" dimension into the macroeconomic policy debate. The merits of the policy are being assessed not only in terms of whether it achieves its macroeconomic objective, i.e. a lower inflation rate, but also in terms of its impact on specific interest groups in the economy.

The argument that the exchange rate should be insulated from the impact of monetary measures, so that exporters are left untouched, naturally leads to the question: why single out exporters? Are there no groups in the economy which will benefit from rupee appreciation and, if there are, who is to say that their gains are outweighed by the gains to exporters from resisting rupee appreciation?

Actually, we can widen the scope of the question to address the political economy dimension of the overall monetary policy position. Who gains and who loses from the implementation of any combination of monetary instruments? And, can one use this analysis to help achieve the macroeconomic objective of the policy with the minimum overall cost across all the groups in the economy?

A complete answer to that question would involve a rather elaborate modelling exercise. Given the rapidity of change in the Indian economy, we have enough problems in building even simple models involving a small number of variables, let alone something as comprehensive as is needed to address these political economy questions. However, short of a full-scale model, even some preliminary qualitative analysis would help policymakers gain some insight into the distributional consequences of their decisions.

We could begin by looking at the very objective of monetary policy, the inflation rate, in this vein, but that would take up too much space. Let's take it for granted that a lower inflation rate is beneficial to a large majority of the interest groups within the economy and move on to the instruments.

Higher interest rates obviously have an immediate impact on borrowers, whether they borrow for consumption or investment. But, they are favourable for savers and lenders, who would have a greater incentive to do these things as interest rates rise. The impact on banks and financial intermediaries is ambiguous, since this category both borrows and lends. They would both earn more from and pay more for their lending and borrowing respectively, but would deal in smaller volumes.

In some ways, the impact of a hike in the cash reserve ratio (CRR) is similar, because it eventually results in higher interest rates. However, there is a critical difference between the effects of a hike in the interest rates and the CRR on banks. By forcing banks to divert a larger proportion of their portfolio to relatively low-yield cash deposits with the central bank, a CRR hike reduces the banks' abilities to take advantage of higher market interest rates. Thus, banks on the whole are likely to be worse off when the CRR is used as an instrument, relative to when it is not.

All of the above can happen without regard to the exchange rate, which could conceivably be appreciating or depreciating in response to movements in the balance of payments. However, complications arise when there is a desire to control the exchange rate in a situation of persistent balance of payments surpluses. This requires the central bank to buy up the entire surplus. If the central bank wants to sterilise this, i.e. insulate the domestic money supply from it, it has two options.

One, it can sell government securities to the banking system, which raises interest rates on subsequent issues of bonds, thereby raising the costs of government borrowing. There is, therefore, a fiscal impact. Two, it can simply sequester the amount it pays banks when it procures the foreign exchange""force them to maintain the amount received in the form of cash deposits with itself. There is no direct fiscal consequence, but banks are adversely affected, as an even larger proportion of their portfolio is now in low-yield deposits.

In short, either the government or the banking system pays a price for resisting exchange rate appreciation with the use of sterilisation. Who else has to pay a price? Anybody whose business depends on imported inputs also bears a cost. To the extent that these inputs can also be produced domestically, these costs may be offset by the gains that accrue to those domestic producers. However, if there is no domestic competition for the supply of inputs, the impact on whoever uses them is unambiguously adverse. Likewise, consumers, who might benefit from cheaper imports, are being forced to consume more expensive domestically produced goods.

Countering these are the gains accruing to exporters, both of goods and services, which are currently a primary focus of the debate. The major reason why the impact of an appreciating currency on exports receives so much attention is that these are perceived to be relatively labour-intensive, particularly in the unskilled and semi-skilled categories of workers. Preserving these jobs is clearly an important objective of overall policy. These gains are supplemented by the gains to domestic producers who compete with imports, although these may be limited as pointed out in the previous paragraph.

From this perspective, the fact that the Reserve Bank of India decided in April to stop resisting the pressure on the rupee to appreciate can be interpreted as an assessment that the costs outweighed the benefits. The aggregate adverse impact of maintaining the exchange rate on the government and/or the banking system and users of imported goods was more than could be justified by the gains accruing to exporters and, ultimately, the workers that they employed.

Given the overarching objective of keeping the inflation rate under check, does the current policy configuration provide the "least-cost" solution? I clearly do not have an answer yet, but I think that framing the question in this way will both generate a more constructive debate and a more efficient policy solution.

The author is chief economist, Crisil. The views here are personal