We are close to reaching that point in the business cycle when the impossible trinity of macroeconomics is going to trouble a number of central banks, particularly RBI. Very simply, the impossible trinity means that a central bank cannot allow free capital inflows, keep a fixed exchange rate and run an independent monetary policy, all at the same time. It can, at best manage two, but must sacrifice the third. However, governor Subbarao, in a speech two months ago, reaffirmed RBI?s commitment to managing the impossible trinity as best as possible.
Here?s the complicated scenario that?s building up for RBI on the eve of its credit policy statement. After the glut of the crisis, there has been a massive return of foreign capital inflows, primarily into the stock markets, which is putting upward pressure on the rupee. Not unrelated to the inflow of capital into India and other emerging economies, is the decline of the dollar, which is directly linked to investors increasingly opting to move out of the safety of the dollar now that the crisis has ebbed.
Of course, the decline of the dollar is commonly viewed as good for the global economy, and it indeed is. It should help address the imbalance between massive US deficits and huge surpluses in China, Japan and Germany, an imbalance that many view as the core of the financial crisis that unravelled last year. Going into the future, the US clearly needs to consume less and export more, and China, Japan and Germany need to consume more internally. A decline in the dollar vis-?-vis the yuan, yen and euro is the smoothest way to correct this imbalance. The only hitch is whether China, which has manipulated to undervalue its currency for years, is willing to revalue the yuan. If it continues to track and undervalue the declining dollar, much of the adjustment will not happen. Worse, it will force countries like India to bear the cost of an adjustment of the US economy, a cost which we in India may find expensive to bear.
India is not a surplus economy like China, Japan and Germany. And yet, over recent years, our dependence on exports as an engine of economic growth has only grown. The exports of goods & services together account for some 21% of GDP, which means that any squeeze here, will affect the probability of hitting 9% growth adversely. And it?s not just growth?a lot of employment forms part of the Indian export equation, too. An appreciation of the currency beyond what is viewed as reasonable (say the Rs 42-45 range) may therefore be devastating for exports and economic growth. It may be politically impossible for RBI to justify letting the currency grow stronger than that even if that?s what the free market would require it to do.
There will be another complication for RBI and that?s the timing of its interest rate hike?what is now referred to as the exit strategy . If RBI proceeds to hike interest rates ahead of the US, this will attract another deluge of foreign capital, which will further increase the pressure for appreciation. And from all accounts, it seems clear that RBI is in a more hawkish mood than the US fed is?the latter seems committed to maintaining looseness in monetary policy for a while yet.
So, how will RBI manage its desire to hike interest rates ahead of the US, with maintaining a fair-value exchange rate and allowing capital inflows to enter? The simple answer is that it can?t?the impossible trinity.
Two case studies from elsewhere in the world are instructive. Take the case of Australia first whose reserve bank was the first G-20 central bank to push the exit button by hiking policy rates. However, the governor of the Reserve Bank of Australia went on record saying that an appreciation of the Australian dollar was not his concern, and indeed not a concern for the country. Should Subbarao hike rates today or indeed anytime over the next few months before the US fed does, will he be brave enough to say the same?
Now consider the case of Brazil. Like India, Brazil has faced a massive inflow of foreign capital into its stock markets as recovery has taken hold and investors have exited US treasuries. This put enormous upward pressure on the Brazilian Real, something which would have hit Brazil?s exports. The central bank could have cut interest rates to prevent an appreciation, but that is not in line with its autonomous monetary policy stance. Instead, it chose to curb capital inflows by imposing a 2% tax on the purchase of equity and bonds by foreigners. Almost immediately, there was some (but not massive) outflow of capital and the Real depreciated. In essence, the central bank chose to manage the exchange rate and keep autonomous monetary policy and sacrificed free capital flows. Will D Subbarao (or the government) be brave enough to impose a Tobin tax (a nuclear, last resort option really) on inflows so that he can hike interest rates and manage exchange rates?
One doesn?t envy governor Subbarao?s position. But if bravado is his only way out of a difficult situation, he may want to choose a third option. Consider an interest rate cut now?it will boost the economy, prevent appreciation and leave capital flows untouched. And he should shut his mind to irrational fears on inflation. It isn?t demand/ credit driven yet and it won?t be for many months. Take the right plunge, governor.
?dhiraj.nayyar@expressindia.com