Dollar doldrums

The problem started when RBI ran out of its stock of government bonds. It then turned to the government to issue Market Stabilisation Scheme MSS bonds that were meant solely to sterilise its foreign exchange intervention. The pace of sterilisation slowed down as its cost became transparent. For example, in 2006-07, the government paid Rs 2,600 crore as interest on these bonds. The last nine months have seen large-scale unsterilised intervention by RBI. As a consequence, money supply increased sharply as new money created grew at 29 per cent compared to 17 per cent last year.

High money growth was accompanied by high inflation. To counter inflationary pressure, RBI stepped down its intervention in foreign exchange markets in March and the rupee appreciated sharply. Cash Reserve Ratio CRR and interest rates hikes were deployed to reduce liquidity. But these led to sharp interest rate shocks. Higher interest rates began attracting more capital and also raised concerns about investment slowing down. Subsequently these were countered by lack of sterilisation, which resulted in zero interest rates in the overnight inter-bank market. There was complete confusion on monetary policy as RBI struggled to tackle one problem after another.

At every stage the fire-fighting caused fresh problems and more instability. As a policy framework this is ultimately futile, because it is rooted in inconsistency. The central bank is being asked to deliver conflicting objectives that cannot be all obtained at the same time. To put it in a somewhat simplistic fashion, the picture looks like this: one month politicians scream about rising prices and so RBI keeps away from the foreign exchange markets and brings down the inflation rate; the next month exporters scream about losses due to rupee appreciation, and RBI steps back in and buys dollars to keep the rupee weak. This time it sterilises its intervention to prevent inflation and raises the Cash Reserve Ratio. But now interest rates go up. Households and firms scream about higher interest rates and RBI stops intervening and liquidity hits the economy. The cycle starts all over again.

One way to manage both the exchange rate and inflation is to go back to being a closed economy. However, as the Prime Minister8217;s Economic Advisory Council report notes, any restriction on foreign investment 8212; FDI or FII 8212; will be ad hoc and 8220;most unwise8221;. Policy continuity is an essential element to initiate and maintain such flows.

Can restrictions on debt flows such as external commercial borrowings ECB, which are allowed up to a gross limit of 22 billion, help? In 2006-07, 473 billion entered India. Of this, 21 billion was on account of ECB. The impact of blocking ECB can only be marginal. Today if India opts to restrict dollar inflows on a serious scale, it can be done only through very drastic restrictions on investment and trade, with drastic implications for India8217;s economic growth.

In addition to growth, globalisation has also meant a much larger flow of foreign exchange in and out of the country. India8217;s annual foreign exchange market turnover has grown to a gross of 6.5 trillion in 2006-07 from 1.4 trillion six years earlier. There has been a sharp increase in the average daily turnover in the foreign exchange market from 24 billion last year to 38 billion this year. This means it has become increasingly difficult to manipulate the rupee. The amount of dollar purchases required to make an impact on the price of the dollar is higher when larger volumes are involved.

In end-October 2006 the rupee stood at Rs 45.47 per dollar. From November 2006 to July 2007, RBI purchased about 28 billion in the foreign exchange market, an average of 3 billion per month. Despite this, the rupee moved to Rs 40.77 per dollar by end-July. If the rupee is to be kept weak, increasing amounts of dollar purchase will be required. If this is unsterilised, it will result in inflation. If it is sterilised, it will result in higher interest rates and lower investment. Considering that investment not exports is the biggest engine of growth in the Indian economy today, intervention, whether sterilised or not, is a very costly option. Instead of helping GDP growth through higher exports, it could reduce investment and growth through higher macroeconomic instability.

The government must recognise that it cannot have it all. It must decide where it wants to be two years from now and take steps to get there with the least pain. If investment and low inflation are to take precedence, it must move towards greater currency flexibility. A road map towards a consistent monetary policy framework needs to be created. RBI would have done the government a favour by laying it out in the credit policy. However, the responsibility lies with the government. These are after all political choices. The government must now act.