January 28, 2006
The RBI recently raised the interest rate for short-term borrowing. When do central banks raise interest rates and why did RBI make this move?
One rationale for raising interest rates is to curb inflationary pressures in the economy. Interest rates are raised to curb investment by firms and loan-financed expenditure by households. This reduces the demand for goods and combats inflation. But inflation has been under control and has not shown signs of rising. Like the rest of the world, India has suffered from higher oil prices but, as with the rest of the world, this has not led to serious inflation. RBI’s decision cannot be explained by inflationary fears.
Yet another argument for raising rates is when the economy is “overheating”. The term loosely refers to a sharp rise in investment, and a sharp rise in wages, which would eventually feed into inflation. All market economies go through cycles of this nature. Monetary policy is used to smooth the cycle. When the economy is “overheating”, and inflation is expected, higher interest rates serve to curb investment by firms and loan-financed purchases by households.
But is the economy “overheating”? The government is talking about sustained 8 to 10 per cent GDP growth, so surely a quarter or two of 8 per cent growth is not overheating. Moreover, in recent weeks there have been signs of slower growth of corporate profits and expectations that credit growth is likely to slow down. There is a view that that we may already be at the peak of our business cycle and are now heading towards slower growth. In such a situation, “an overheating economy” cannot be cited as a reason for raising rates.
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Over the last 15 years, India has been witnessing business cycles similar to those in industrial economies. These have been periods of high growth — with high investment and high wage growth — in the economy followed by periods of slower growth. The main objective of monetary policy is to smooth this cycle, to increase the happiness of households by not subjecting them to this macro-economic volatility. But, as the latest rate hike shows, monetary policy in India does not seem to respond to the requirements of the ups and downs of the Indian economy. Why then did the RBI raise rates? A key explanation is the increase in interest rates by the Federal Reserve Bank of the US. The Fed has been hiking rates in response to the needs of the US business cycle — as they should be doing. But why should that affect RBI in India? And why should it force the RBI to do something which is actually out of touch with the needs of the Indian business cycle?
The answer lies in the RBI’s focus on controlling the rupee dollar rate. India does not have a fixed exchange rate vis-a-vis the US dollar. We have a “market determined exchange rate” which, de facto, is pegged to the US dollar. This means that while the RBI does not fix the rate through an announcement, it actively trades in the currency market, to control the rupee-dollar rate. Thus the rate is indeed determined “on a market”, but the RBI is the ‘market operator’ who forces the market to have a price chosen by RBI. In addition to trading on the currency market, RBI also uses interest rates to influence the inflow and outflow of dollars, so as to have a say on what the exchange rate should be.
This is where trouble arises. In an increasingly open economy, money moves across the border in an increasingly free way. RBI tries to have an elaborate system of controls, but these achieve little, since over-invoicing and under-invoicing of exports and imports can be used to move billions of dollars across borders. This means that the RBI has to mightily struggle in order to control the exchange rate. All of monetary policy increasingly gets used up to control the exchange rate. If the RBI fears that capital would leave India because interest rates in the US are relatively higher, and if the RBI wants to hang on to the present exchange rate, it has to raise interest rates in India.
The recent repayment of IMD is said to have “caused” a $7 billion reduction in reserves, and a tightening of monetary conditions. But these symptoms are directly related to the pegged exchange rate. If RBI did not have a pegged exchange rate, we would have seen a slight depreciation of the Indian rupee in December and no sale of dollars by the RBI or the resulting liquidity tightening.
Similarly, RBI’s concern about the current account deficit can lead in two directions. Either the rupee can be allowed to depreciate, resulting in higher exports and lower imports or, alternatively, if the policy is to prevent the rupee from moving, import growth could be slowed down by choking growth in the economy as a whole through raising interest rates. The latter policy was chosen.
In other words, RBI’s monetary policy is primarily concerned about stabilising the exchange rate. The problem with this is that as India has become more and more open, most of the power of Indian monetary policy gets used up to obtain exchange rate stability instead of stabilising the domestic economy. Most central banks today understand that volatility of GDP is more important than the volatility of the exchange rate, and monetary policy has shifted to focusing on the domestic business cycle. The European Central Bank — which does not trade on the currency market — can afford not to raise interest rates even when the Fed does, based on its judgment about the European business cycle.
Openness of the Indian economy is a reality today. We have two choices. Either we can cater to the needs of the domestic economy, or we can continue to focus on the exchange rate and effectively hand over Indian monetary policy to the Fed. The latter may be possible for a small country, but for an economy the size of India’s, this is a costly choice. India has changed. Now our thinking in monetary economics also needs to change.
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