The Reserve Bank of India’s lost policy lever

The Reserve Bank of India’s (RBI) hands-off exchange rate strategy has resulted in a missed opportunity to curtail inflation.

Intervention in the foreign exchange market would have helped counter inflation; but the RBI has failed to grasp such a dexterous policy tool. India is currently experiencing chronic and high inflation; a large fiscal deficit with falling revenues; a wide current account deficit overtly dependent on short-term portfolio capital, which has reversed rapidly; slowing growth with no prospects for investment recovery; and a flat stock market overseeing earning downgrades. These are evidence of a precarious macroeconomic situation. Monetary and fiscal policies are both overstretched. Intervention would have been an adroit move to get out of this blind alley — but the RBI has been a mute spectator focused on increasing interest rates instead. Has it missed out on a useful policy lever by not accumulating foreign exchange reserves in recent years?

Between the end of July and October, the rupee crashed 13 per cent. This comes at a time when monetary responses have been exclusively geared toward fighting inflation, which has been a serious issue since 2009. Non-food core inflation (around which monetary responses are framed and which reflects imported input prices, including oil and commodities) has averaged 7.6 per cent for over eight months now. During the same three-month period, the price of imported crude oil and commodities both fell significantly. Yet this bounty has not been exploited to guide the economy out of the cul-de-sac of high inflation, slowing growth and an investment standstill; ultimately, the rupee tanked! The rapid and sustained currency depreciation has not just offset the gains that a decline in crude oil prices would have had on inflation, but it has also added to price pressures by raising the cost of imported items. Two rounds of oil price increases have accompanied the rupee’s fall, which worsened already-strained public finances by increasing the oil-subsidy burden. And so an economy that traditionally benefits from falling oil and commodity prices, being a large importer, has actually been pushed deeper into the spiral of inflation-low investment-slowing growth.

Meanwhile, the RBI has continued to plod along the interest-rate path in an effort to restrain inflation, raising rates in September and then again in October. The bank has thus added a further challenge to its job of managing inflation. Is it the hands-off exchange rate strategy or a diminished capacity to intervene that explains such macroeconomic management?

Since 2009, the RBI has largely kept its hands off the exchange rate, barely intervening in the currency markets; net purchases in this period add up to just US$3 billion. Since capital inflows were good — due to a combination of rising stock prices, growth and an appreciating currency — capital account surpluses from short-term portfolio flows generously financed a growing current account deficit as imports grew much faster than exports. Reserve accumulation came to a standstill as the rupee floated freely, whereas external debt, especially short-term debt, grew rapidly. Now the reserves’ adequacy ratio — the extent of overall debt, long-term and short-term, backed by foreign exchange reserves — has fallen from a peak of 138 in June 2007, to 100 in June 2011. This means the buffer against unanticipated external shocks is relatively weak. One should also mention that global risk, uncertainty and volatility following the 2008 crisis have not yet subsided — perhaps they have only increased.

So even though India’s foreign exchange reserves (excluding gold), special drawing rights and reserve position at the IMF amounted to a handsome US$277 billion in June 2011, it would appear that India’s capacity to check a sudden and rapid slide in the currency’s value is significantly reduced.

Or, as the RBI governor stated recently, is the exchange rate simply not used to manage inflation?

If a hands-off exchange rate policy is best for India, the question is whether the economy’s structure supports such a policy. The economy’s fundamentals remain shaky with two large deficits, one of which is heavily dependent on the fickle drip of portfolio flows. India is highly prone to inflation, and its financial markets are still not deep enough to disperse and dissipate shocks from abroad.

Given these factors, foreign exchange reserves serve as an important lever for the short-term management of cyclical winds. If this tool — a critical one — is no longer at India’s disposal, then what are the alternatives? Should India scrounge for foreign institutional investments in the debt market to support the rupee? Or should the country take it on the chin as it is currently doing?

By Renu Kohli macroeconomist at the Indian Council for Research on International Economic Relations, New Delhi. She has also worked for the International Monetary Fund and the Reserve Bank of India.
A version of this article first appeared here at the Business Standard