What RBI wants
Business Standard, 4 April 2007
While the public posture of RBI emphasises inflation, the actual actions of RBI have injected large amounts of liquidity, and thus fueled inflation, from October 2006 onwards. The true monetary policy, that is acted out under a shroud of secrecy, is dominated by RBI's trading on the currency market. In the latest six months, while RBI has publicly taken a stance of tighening liquidity, it has injected huge amounts of liquidity into the system. Does RBI care about inflation in the way Parliament does? This situation may require a rethinking of the contractual terms under which monetary policy is outsourced to a monetary authority.
Politicans and professional economists agree on the importance of achieving low and predictable inflation. In India, the institutional framework of policy for achieving and maintaining inflation is not in place. Starting from 3% CPI-IW inflation in 2004, inflation slipped out of control. The UPA government has introduced a series of distortions in the real economy in response. These measures do little to affect inflation, which is a macroeconomic phenomenon. They only hurt growth.
The tool of choice for achieving reliable 3% inflation, year after year, is monetary policy. The difficulty lies with the agency which wields this tool, which has its own views on what this tool should be used for.
From October 2006 onwards, the rhetoric against inflation has risen to a crescendo. The public face of RBI has emphasised a series of monetary tightening measures. However, under a shroud of secrecy, RBI has purchased USD, thus injecting liquidity into the economy, which has fueled inflation. RBI purchased $3.2 billion in November, $1.8 billion in December and $2.8 billion in January. Between 4/2006 and 1/2007, RBI bought $12.6 billion thus adding Rs 56,543 crore to the domestic monetary base. The overall net effect of RBI's actions has been to fuel liquidity and thus inflation.
RBI's trading on the currency market is a mysterious feature of India's institutional structure. Parliament or the Ministry of Finance have not agreed to an operating manual on how currency trading will be done. RBI staff control a gigantic portfolio of roughly Rs.8.5 lakh crore. They have full discretion on doing active trading using this portfolio on a day to day basis.
The true monetary policy is acted out in this trading, on a day to day basis. However, there is no transparency about these actions. In India, we get daily data about mutual fund transactions on the stock market, which show up in the next day's newspapers. But when it comes to the true monetary policy, we do not observe daily data for RBI's trading. Only aggregate monthly data is released, with a lag of 2 months.
Daily release of data about RBI's currency trading is an urgent need, for two reasons. First, it is a critical element of monetary policy transparency: the economy must know what is the true stance of monetary policy. Second, if such transparency were in place, we may have never got to the Friday sledgehammer. If the broader policy debate was aware of what RBI had been actually doing while it was claiming to fight inflation, this path would have been questioned.
The picture that emerges is one where RBI cares, first and foremost, about the INR/USD exchange rate. RBI likes to talk about inflation and RBI is willing to inflict pain on the local economy, but what RBI wants is a target rupee-dollar rate.
If RBI were serious about inflation, it would not inject liquidity into the economy. The rupee would appreciate - which directly helps combat inflation by reducing the price of imports and by reducing demand for exports, thus cooling an overheated economy. A rupee appreciation directly assists inflation control. But events have shown that when faced with such a choice between pegging the exchange rate and controlling inflation, RBI is not interested in controlling inflation.
Parliament desires a monetary policy which delivers low and stable inflation, while being mindful of the health of the Indian economy. What the present outsourcing arrangement is achieving is a monetary policy which is focused on the INR/USD exchange rate, which is willing to sacrifice inflation and the health of the local economy in order to achieve exchange rate goals.
Looking forward, business as usual will make things worse. RBI will continue to uphold the pegged exchange rate. Through this, they will continue to inject liquidity, thus fueling inflation. This might lead the UPA government to do more damaging things to the real economy, and it will lead RBI to do more monetary tightening.
In a year or two, these twin sledgehammers could get through, and the story of high Indian GDP growth could wilt. Inflation will then come down, but at a very high social cost. When the Indian GDP growth story wilts, capital flows will reverse. At that point, currency-focused RBI will raise rates to defend the rupee, thus giving tight monetary policy at the worst possible time.
Fiat money is a great invention, but it consists of playing with fire. An extremely sophisticated institutional structure is required for a country to harness the benefits of fiat money, without running into these destabilising effects of the monetary policy of a third world country. A considerable intellectual sophistication is now required, in understanding how monetary policy works in an open economy. The mechanical application of traditional operating procedures is out of touch with a new India. Reshaping monetary policy institutions and operating procedures is required, drawing upon the knowledge of countries which have mastered fiat money, such as the UK.
This involves four elements: transparency, accountability, independence and focus. The monetary authority must be completely independent of the election cycle, and be completely transparent in thinking and in action. The monetary authority must be held accountable on delivering an inflation target - the governor should get a year-end bonus based on how well inflation has stayed close to the target, and he should have to appear in public to explain deviations from the target. Finally, the monetary authority must have a full focus on monetary economics, with no extraneous distractions like banking regulation.
Politicians in India believe that hunger and malnutrition is their top priority. As events have demonstrated, they need to realise that rewriting the RBI Act of 1934 is a essential way station on the road to eliminating hunger and malnutrition.
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