The Chinese yuan has crossed the psychologically significant 7 yuan per US dollar mark. And the immediate reason for this is purely domestic?far from the persistent ranting and ravings of US legislators and officials clamoring for a reduction in China?s staggering trade surplus with the US. China?s inflation touched an 11-year high of close to 9% in early 2008, prompting it to move progressively away from the peg it has so fervently defended over the years.
This is a classic example of what is known as the ?impossible trinity? of international finance. Put simply, three things?free flow of capital across national borders, a fixed exchange rate and monetary policy independence?cannot co-exist. The reasoning is not difficult to see. If money is allowed to flow freely to and from a country, then the country?s interest rates have a direct bearing on the amount of cross-border currency flows. A higher interest rate, for instance, will attract a gush of foreign capital. Given a fixed exchange rate, every dollar flowing in translates into a fixed amount of local currency pushing the money supply up. Thus, the interest rate, the primary monetary weapon to fight inflation, loses its efficacy. The government, then, has to choose between sticking to its exchange rate target and its inflation target.
The China story has played out this script perfectly. For years, China maintained a fixed exchange rate against the dollar. With the US crying foul, it relaxed its exchange rate regime slightly in 2005, but the Yuan remained undervalued. This policy certainly helped China flood the world market with its exports as it resisted demands for revaluing its currency. But for years, China also attracted record capital flows from abroad. Under a truly floating exchange rate regime this would have led to an appreciation of the yuan. But the export oriented currency policy led to an increase in money supply in China fueled by the incoming dollars being converted to yuans at the fixed rate. High real growth in China earned it a reprieve for some time but finally inflation began to creep in and the government finally decided to sacrifice the currency policy at the altar of inflation management.
There is an important lesson in all this for India. The recent slide of the rupee notwithstanding, India has faced largely the same dilemmas that China has with broadly similar policy stance. We have piled up a large foreign exchange reserve, though less than a fifth of China?s, and have witnessed a surge of foreign inflows that economic managers have tried to deal with, with limited success, using sterilisation and quantitative controls. Needless to emphasise, in recent months, inflation has been the greatest economic headache of the government in India as well. Part of RBI?s reluctance in using the interest rate in combating inflation doubtless stems from the fear of widening the interest rate differential with the US.
Of late, a key suggestion of the Planning Commission?s Committee on Financial Sector Reforms headed by Raghuram Rajan?that the RBI follow ?inflation targeting??has created quite a stir in both Indian and international circles. (For the sake of full disclosure, I was part of the research team that aided the committee.) Many have argued that inflation targeting is too narrow and simplistic and sacrifices other goals of monetary policy. The arguments have ranged from monetary policy being secondary and impotent in combating inflation in India to professing faith in the intolerance of inflation on the part of India?s political system to handle the situation. Using non-monetary and quantitative measures appears to be the underlying proposition. Thankfully no one has so far suggested that inflation control should therefore be abandoned explicitly as a major monetary policy objective in India.
The Chinese experience is of particular relevance here. Clamping down capital flows is hardly an option and it is not even clear that the government can restrict or manage flows effectively any longer without resorting to full-blown capital controls. Consequently, the government has a choice to hold back either inflation or the value of the rupee. It is tempting to manage the currency value?an appreciating rupee can wreak havoc not just in our software sector but can cause widespread hardship among easily identifiable small exporters like in textiles and leather goods. However, that would be, in effect, a subsidy to these sectors from the rest of the economy, an arrangement whose efficiency as well as distributive fairness are questionable, and whose sustainability is next to impossible.
The China story simply demonstrates the ultimate primacy of inflation control in monetary policy. Once inflation crosses a certain level, monetary authorities are likely to surrender export-promoting currency policy even in a country where the external sector is far more important than in India. The story is likely to be the same in India.
?Rajesh Chakrabarti teaches finance at ISB, Hyderabad