Confusing signals

Has the Reserve Bank of India (RBI) changed its mind on""and its attitude to""capital flows, currency management and how to cope with the problems caused by its established monetary policy? That would certainly seem to be the case, given the sharp rise of the rupee against the dollar in recent weeks. Perhaps the continuing strength of the capital inflow made it impossible for the RBI to continue with the old policy of trying to keep the rupee down by buying dollars and then sterilising the rupee funds that were generated by this action so that inflation did not get out of hand. Inflation was refusing to come under control, the dollar inflow was intensifying and monetary policy was coming unstuck""with higher interest rates causing their own problems. A change of tack may therefore have become inevitable.

From November 2006 to February 2007, the Reserve Bank of India spent Rs 88,000 crore to buy $19.7 billion on the currency market. These purchases are now worth about Rs 80,000 crore today, so the fall of the dollar has meant a substantial loss. An interest cost of 7 per cent, applied on Rs 80,000 crore worth of securities issued to sterilise rupee funds, would mean a further outflow of Rs 5,600 crore a year. Those are big numbers: Rs 14,000 crore would build a national highway from Delhi to Kanyakumari. But the true costs of the RBI's currency policy are even bigger. If dollar assets in November were $100 billion, a 10 per cent currency appreciation imposes a fiscal cost of 1 per cent of GDP. On top of that, there are costs owing to the poor returns on the reserves portfolio. The biggest cost of the policy, however, is not fiscal but political. Only a partial sterilisation of the dollar inflow was possible. As a result, in 2006-07, reserve money grew at 24 per cent, in contrast to 17 per cent in the previous year, resulting in higher inflation, which is politically unacceptable.

A higher external value for the rupee, which results from allowing the dollars to flow in and the RBI choosing not to intervene, is not without costs; the export slowdown that is already visible is one result. That is what has now made proponents of an activist currency policy unhappy, mindful as they are of what an export slowdown can mean to GDP growth and other macro-variables. The question is whether the RBI had a choice. Certainly, Y V Reddy, the RBI governor, seems to be singing a new tune after abandoning the erstwhile currency policy. With rising interest rates, inflation rates and money supply, the problems of monetary policy in India are visible to all. The question is whether a critical switch has been made in recent weeks, from the policies which worked fine in a closed economy, to a different policy matrix more in tune with an economy that is integrating with the rest of the world. The RBI does not make clear whether this is the case, and certainly its policy pronouncements should be different if it has indeed changed tack.

The centrepiece of a monetary policy statement is the central bank's forecast of future inflation, which should guide interest rate setting today. Last week's policy statement desires inflation of 4-4.5 per cent, but does not offer a path to that destination. While the stock market has been ecstatic because interest rates have not been jacked up again, the underlying problems remain. The government will want consumer price inflation to be no more than 3 per cent by 2008-09, so it is possible that the RBI may have to surprise markets again.