India’s untenable currency policy

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: 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.