There has been considerable discussion on the merits of the RBI interventions in the currency markets, to halt a precipitate appreciation of the rupee on the back of a tidal wave of capital funds inflows. It has been contended that this has increased liquidity, which has then contributed to inflation. We will not, here, delve into the normative question of the merits of this intervention and the entirely separate story of the links between money supply growth and inflation. The purpose here is to quantify the magnitudes of contributions of the separate components to money supply growth.
There are three major ?sources? of demand for broad money, M3: (a) bank credit to the government (b) bank credit to corporates and (c) foreign exchange assets of the banking sector. Bank credit to the commercial sector still accounts for the largest share of M3 annual stock, but forex assets has had an increasing share since FY 2007, natural given India?s increasing integration with the global economy, as well as the two periods of heightened RBI intervention in forex markets. Forex assets of the banking sector are almost completely with the RBI, as part of its foreign currency reserves.
The shares of these three items, in accounting terms, are mostly larger than 100%, and the balancing is done through a fourth component, ?net non-monetary liabilities of the banking sector? (NNML), which does not have a monetary impact. Besides capital and reserves, they include revaluation on account of changes in prices of securities and exchange rates.
Changes in the foreign exchange assets of the RBI have three major components: (a) actual interventions by the RBI in the currency markets; (b) revaluations of the reserve stock held in different currencies due to currency changes of the US dollar; and (c) interest accruals on the invested portions of the reserves. While the RBI reports the effect of revaluation changes in reserves on a quarterly basis, an approximation of interest earned needs to be deduced, which brings in an element of ambiguity into the calculations.
A more direct measure of the effects of the RBI?s intervention on M3 is through measuring the reported interventions by the RBI, which are not susceptible to valuation changes, and without the interest earnings. There is, of course, an effect of the RBI?s intervention in currency futures, whose unwinding would have a liquidity impact, but this has been absent till the end months of 2007.
The full effect of the intervention is not passed through to M3, since part of it is sterilised, mostly through the issue of Market Stabilisation Scheme (MSS) securities. Some part of the liquidity injection is also neutralized through the Liquidity Adjustment Facility, but this?being the surplus in the banking sector arising from other components such as deposit and credit growth?does not have as clear a linkage as the MSS.
Given this backdrop, the chart plots the contributions of the components in M3 annual increments and is almost self-explanatory. The net effect of the RBI?s sterilised intervention in currency markets on incremental M3 is 30%. The impact of the RBI?s intervention is evident during 2007-08, when its share of M3 increments doubled from 15% to over 30%. In rupee terms, RBI intervention in the spot currency markets in 2007-08 almost tripled to Rs 3,54,000 crore from 2006-07 levels. At the same time, the RBI mopped up Rs 1,05,000 crore through MSS issues, which was also virtually triple its 2006-07 extraction. This resulted in an approximate injection of Rs 2,49,000 crore of domestic liquidity.
That the RBI has contributed to increasing money supply is unquestionable; its own data stands testimony to this. That this increased money supply has partially contributed to inflation is probably also true; the RBI?s own monetary policy stance emphasises this.
However, to attribute the current burst of inflation to the actions of the RBI a year back is over-reaching. The Bank of England (BoE), one of the prototypes of an inflation targeting central bank, has failed to staunch inflation in the UK, leading to the very rare spectacle of the Governor of the BoE having to publicly explain his institution?s failure to the Chancellor of the UK Exchequer.
The RBI does not have a statutory mandate to target inflation, period. Its mandate is to promote growth with stability. A large central bank with a similar mandate is the Federal Reserve Board of the US, and consider its actions during the current credit crisis. Central banks face difficult choices in balancing often-conflicting objectives. The Fed threw out textbook moral hazard considerations by acting to contain a clear and present danger of financial markets collapse. Its actions provided a ?public good? which the other central banks used to focus their actions on inflation control. So too did the RBI, to contain the fallout of a potential collapse of exports, an important segment of India?s growth engine during a period when the currencies of many of India?s main competitors remained stable or depreciated.
The author is vice-president, business & economic research, Axis Bank. These are his personal views