Since the days when C Rangarajan was Governor, the Reserve Bank of India (RBI) has been very keen on sterilising its foreign exchange intervention. When the RBI buys dollars on the market, this injects rupees into the economy. “Sterilisation” is done to undo the damage and regain control of local monetary policy.
Between 1993 and 1995, sterilisation was attempted by raising the cash reserve ratio (CRR). From 2001 to 2004, fairly effective sterilisation was done by selling government bonds. When it ran out of bonds in early 2004, the RBI approached the ministry of finance to set up the Market Stabilisation Scheme (MSS). Bonds under this scheme are sold by the RBI for the purpose of sterilisation. The money thus obtained is kept immobilised in an RBI current account. Interest payments on MSS bonds are one explicit fiscal cost of sterilisation.
In recent months, the RBI’s scale of currency trading without sterilisation has gone up hugely. Every RBI staffer knows that large-scale purchases of dollars without commensurate sterilisation will bloat reserve money growth and ignite inflation. Why is the RBI doing this? Its dollar purchases are injecting rupees into circulation. This lowers money market lending rates and tends to reduce capital inflows.
In the language of modern macroeconomics, however, the RBI is opting for a pegged exchange rate with a fairly open capital account—thus ceding control of monetary policy. The short-term interest rate is explicitly controlled by the demands of currency trading.
At first blush, it appears that the central bank has a consistent solution to the problem of the impossible trinity: peg the exchange rate and give up monetary policy. Such a path is indeed feasible in terms of economics. The trouble is, this solution is not politically sustainable. The policy of unsterilised intervention runs afoul of the low inflation tolerance of the Indian voter and politician. The recent surge of reserve money growth will feed back into inflation with a lag of a few months. Even if the UPA leadership is okay about inflation right now, it will soon have to go on high alert when the inflationary consequences of the recent unsterilised intervention show up—and electoral preparations begin.
Can new ways for sterilisation be found? The fiscal costs work out to be untenable. The present run rate of purchases by the RBI works out to roughly $50 billion a year. Without sterilisation, this involves adding roughly Rs 200,000 crore to reserve money, or an unacceptable 28% growth rate. Suppose a growth rate of 14-15% was acceptable. Then this involves fresh MSS issuance of Rs 100,000 crore per year.
If this is done, then within a year, the stock of MSS bonds would go up to roughly Rs 200,000 crore. The annual interest cost on this would be roughly Rs 15,000 crore. Politicians would not be amused at the RBI’s imposing such a massive fiscal cost.
Further, this scale of purchase—of $50 billion per year—will go up over the years. India is globalising rapidly. The scale of trading required by the RBI to achieve market currency manipulation grows bigger over time. The sale of MSS bonds drives up interest rates and attracts capital flows. Hence, MSS issuance of Rs 100,000 crore per year is only a starting point—things get worse beyond that. Hence, the intensification of sterilisation is essentially infeasible.
Unsterilised intervention induces inflation—and politicians will not accept that. Sterilised intervention requires wasting Rs 15,000 crore a year soon and much more beyond—politicians will not accept that either. In other words, the RBI’s defence of the Rs 40.25 per dollar exchange rate is untenable.
If the RBI was doing unsterilised intervention in the hope of allowing low interest rates in India to deter capital flows, this hope is proving to be misplaced. Global currency speculators have watched many developing countries flounder when faced with the impossible trinity. They understand India’s difficulties with sterilisation, and the country’s low tolerance of inflation. They know that two moves ahead, we will have a disruptive and sharp currency appreciation—like that of March 2007—from which they will profit handsomely. The RBI’s policy stance is actually sucking in a surge of capital flows.
A consistent monetary policy is one that is speculation-proof. The Bank of England never gets into a dogfight with speculators. It learnt its lessons in 1992. Now it calmly targets inflation. An inconsistent monetary policy invites speculative capital flows. The policy mistakes of the RBI are a source of risk. They induce unstable speculative capital flows.
The defence of the dollar is the root cause of these difficulties. The task of the credit policy announcement on July 31 is to show an exit strategy from this no-win situation. The goal must be to improve on the messy events of March 2007, when the rupee appreciation took everyone by surprise while the RBI stayed resolutely non-transparent. This requires improved transparency and communication by the central bank, and a programme to increase currency flexibility.
—Ila Patnaik is senior fellow at National Institute of Public Finance and Policy. These are her personal views