Central bank misrules

Those who fix rates must learn from history. RBI clearly has not

The double-barrelled attack on inflation is more posturing than good economic policy. In the last four years, preventing rupee appreciation and risking high inflation was a policy choice made by the government and RBI. Today8217;s inflation is the natural consequence of this political choice. Fire-fighting inflation with sharp hikes in interest rates will now do more harm than good. What is needed is long-term reform.

We have seen this movie before. In the mid-8217;90s, RBI fought a grim battle to prevent the rupee from appreciating in an attempt to subsidise exporters. From March 1993 to September, the exchange rage was kept between Rs 31 and Rs 32 to the dollar. Over this period, RBI added 12.6 billion to its reserves in its effort to prevent the rupee from appreciating. Dollars were purchased, rupees were injected into the domestic economy, and growth in the monetary base rose to 20 per cent per annum. Not surprisingly, inflation took off. Interest rates were used to combat inflation. The 91-day rate went all the way up to 13 per cent by November 1995 in this fight against inflation. RBI won this fight. But many people believe that this increase in interest rates led to the souring of a remarkable phase of high GDP growth.

Now we have a second edition of the same story. Once again, currency pegging has perverted domestic monetary policy, and ignited inflation. RBI fought a grim battle to prevent the rupee from appreciating in an attempt to subsidise exporters. After three years of high liquidity growth, even after early 2007 when the first signs of inflation started appearing, RBI added 110 billion to reserves in its effort to prevent rupee appreciation. Dollars were purchased, rupees were injected into the domestic economy, and growth in the monetary base rose to 31 per cent. With a huge stock of liquidity in the system, a shock in global commodity prices ignited high inflation in the domestic economy. RBI8217;s monumental mistake was then to engineer a rupee depreciation that pushed up prices even further. It then stood by passively and watched as the rupee depreciated and prices spiralled.

The first and most obvious question to ask in this story is about RBI8217;s focus on inflation: why does RBI not learn from history? Why does RBI obsess with currency pegging, even though it has led to such costly distortions of monetary policy? Why is subsidising exporters more important than delivering low and stable inflation? Why does RBI have a greater loyalty to exporters than it has to the local economy?

Or is it that 8212; since RBI is not an independent central bank 8212; the 8220;prevent appreciation, risk inflation8221; loose monetary policy was the policy choice of the government? Would RBI have focussed on inflation if it were an independent central bank? To address this issue, the Percy Mistry and Raghuram Rajan reports on financial sector reforms in India have recommended that RBI be made an independent central bank with a focus on inflation.

The second and more subtle question to ask is: Why do central banks in mature market economies manage to combat inflation by gently nudging rates up? When interest rates are used to combat inflation in India, why are savage hikes required?

This brings us to the 8220;monetary policy transmission8221;, the term used for the process through which an increase in the short-term interest rate by the central bank propagates into changes in interest rates all across the economy, thus pulling back demand and slowing inflation. In India, the monetary policy transmission is largely dysfunctional. Because monetary policy is enfeebled, if a certain reduction in inflation is called for, very large changes in the policy rate are required. Central banks in mature market economies have a more powerful monetary policy transmission. Hence, they are able to control inflation through small changes in the interest rate.

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Why is monetary policy enfeebled in this fashion? The answer lies in two parts. As Nachiket Mor and Paul Levine have independently pointed out, the large informal sector has been cut off from formal finance. Changes in the policy rate do not impact upon this group. Over half of the economy, then, does not participate in the monetary policy transmission.

The second story is in the formal sector. In mature market economies, the 8220;bond-currency-derivatives nexus8221; BCD nexus is the complex system of markets through which a small change in the policy rate propagates across the economy into interest rates for corporate bonds, interest rates charged by banks, etc. This BCD nexus is lacking in India. There is no corporate bond market to speak of. The large corporations are largely equity financed. Changes in interest rates by banks 8212; for either borrowing or lending 8212; do not quite track changes in the policy rate by RBI.

Through a combination of financial exclusion and the lack of a BCD nexus, monetary policy in India has been weakened. As a consequence, if interest rates have to be used to combat inflation, savage increases in interest rates are required.

Why is there such financial exclusion, and what can be done about it? The Raghuram Rajan report has eloquently diagnosed how, after 50 years of preaching about carrying banking to the poor, the supposedly pro-poor policies of the government are the cause of financial exclusion. Fundamental reforms are required on issues like priority sector credit and the regulation of micro finance institutions to overcome financial exclusion.

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Why is the BCD nexus absent, and what can be done about it? The Mistry and Rajan reports have both diagnosed how RBI8217;s policy framework has systematically prevented the rise of an efficient and liquid BCD nexus. Fundamental reforms are required on issues like a regulatory structure for the BCD nexus, the dismantling of entry barriers, the removal of capital controls, and reforming bankruptcy procedures, in order to achieve a well-functioning BCD nexus.

In other words, there are no short-term solutions.

The writer is senior fellow, National Institute of Public Finance and Policy

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