The dollar continues its downward drift, reaching an all-time low of 1.41 to the euro, and there is sustained upward pressure on the rupee. Despite repeated market interventions by the RBI, foreign exchange reserves reached $261 billion on October 19. The rupee has now appreciated by more than 10% since April and nearly 16% since January. Combined with a rise in interest rates of more than 300 basis points, specially for non-prime borrowers, this has seriously hurt the competitiveness of Indian exports. Export growth has slowed down to 18% during April to August, compared with 27% in the same period last year. The growth slowdown in non-petroleum exports will be even sharper and will show up once detailed data, inordinately delayed, becomes available. Import growth has risen to 31%, compared to 21% last year, and non-oil imports have gone up by a whopping 44%?all of these clearly a consequence of the appreciated currency. Sustained growth in external demand is necessary to maintain the economic momentum, and it will be sheer policy complacency to believe that India can rely solely on domestic demand to achieve its desired rate of growth.
On overheating risks, the RBI is perhaps comforted by its 2007-08 forecast of a lower 8.5% GDP growth. Industrial production, which has so far maintained its momentum with a growth of 9.8% between April and August, will surely be affected by the weakening of export growth. The fear is that this may trigger a decline also in domestic demand and lead to a reversal of the cycle. On the inflation front, the news is mixed. While the WPI-based inflation rate has declined to 3.1%, well below the comfort level of 5%, CPI inflation for industrial workers has reached 7.3% in August. The central bank should note that the core inflation rate based on the CPI (minus the more volatile components of food and fuel) comes out to be 4%. But this masks the fact that the rise in the price of the Indian crude oil basket has not been passed on yet to consumers. The faster growth in money supply, at 22% compared to 19 % a year ago, may have tilted the balance in favour of a CRR hike, notwithstanding the demand for non-food credit, which has significantly slowed down to 22% from 28%.
Faced with these facts, the RBI has chosen to maintain a passive policy stance. It has left all the major parameters unchanged except for raising the CRR by 50 basis points to 7.5%. This is clearly meant to further slow down the growth of money supply, and with it, credit growth to the non-food sector.
It is indeed disappointing that the policy does not even try to address the issue of copious and excessive capital inflows. This is despite the fact that the RBI itself says that, ?the biggest challenge for monetary policy is the management of capital flows and the attendant implications for liquidity and overall stability.? The CRR hike, which will curtail liquidity, is like acting on the symptoms without trying to address the real issue.
The hard reality is that the RBI and ministry of finance will have to contend with this phenomenon of ?excessive? capital inflows sooner rather than later. Here are some suggestions. First, the interest (read repo) rates should be brought down. It will reflect the RBI?s commitment to sustaining the growth momentum for it would have acted as soon as it reached its comfort level on inflation. It will also relieve the upward pressure on the rupee. Foreign capital flows, surging because overseas investors see the double benefit of interest arbitrage as well as a rising rupee, would be dampened. An interest rate cut will relieve exporters and SMEs, as it induces banks to follow the lead taken by SBI and ICICI in lowering rates for this segment. This will improve the balance of trade and also help service sector exports. Finally, this will reduce the cost of RBI?s sterilisation efforts as the interest rate differential between the liabilities and asset holdings of the central bank will be narrowed.
The second measure could be to require FIIs to put their capital inflows in non-interest bearing deposits with the RBI for up to three months before these are used for buying equities. This will lower the return on these inflows and help reduce the upward pressure on the rupee. Finally, the RBI may well consider further enhancing the MSS facility to mop up incoming capital flows to the point that it changes the market perception that the rupee?s exchange rate is simply a one-way bet. To achieve this, market interventions by the RBI may have to be synchronised with those of large public sector players.
Ultimately, however, it is the perception of ?overheating? that informs monetary policy. For this perception to change, the central bank?s advisory committees and internal thinktanks will perhaps have to be reconstituted with a majority of those who consider double-digit GDP growth not only well within the potential range but also essential to achieve inclusive rapid growth. This is the stated objective of the XIth Plan.
?The author is director and chief executive of Icrier, a Delhi-based thinktank, and member of India?s National Security Advisory Board
