A fascinating feature of the reduction in interest rates by SBI was the view taken by many in the media that it was a response to Tuesday’s decision by the US Federal Reserve to cut interest rates in America. There is merit in this perspective. The recent efforts at introducing capital controls, and at raising MSS limits, have not delivered the goods in terms of exchange rate management. Despite attempts at bringing in capital controls, the exchange rate peg that the RBI is trying to maintain continues to require massive manipulation of the currency market. While hard data has not been released by India’s central bank, estimates suggest that its currency trading over the last six months may amount to an average of $8 billion, or Rs 32,000 crore, per month. Despite the bigger MSS limits, its sterilisation has been incomplete: its currency trading has been only incompletely offset by sale of MSS bonds. Large-scale currency market manipulation coupled with only incomplete sterilisation has meant that monetary aggregates are out of control. Reserve money growth is up 32.4% on a year-on-year basis, and M3 growth is up 22.8%. With the system thus awash in liquidity, banks like SBI have found an answer in lower interest rates.
SBI’s decision is logical. It also reflects the loss of monetary policy autonomy that inevitably comes about when the exchange rate is pegged in an economy that has a fairly open capital account for all practical purposes. This outcome is consistent with the impossible trinity rule, which teaches us that when you peg your exchange rate in the context of an open capital account, you lose autonomy over monetary policy and end up “importing” the policy of the peg currency’s country (the US, in this case). The interest rates that apply under market conditions, therefore, are not always what the RBI wants. In the short run, this outcome is inevitable and unremarkable. But deeper questions about the monetary policy framework persist. Should India continue to destabilise financial markets by sporadically tinkering with capital controls, even though these have proven to be ineffective? Should India not regain monetary policy autonomy? How should the RBI Act be rewritten to give India a monetary policy institution that is commensurate with challenges of the 21st century?