With the inflation rate breaching the 11% mark for week ended June 7, there is no doubt that the RBI will now swing into action with more rate hikes. However, the problem with these possible would-be measures is the recent exchange rate management strategy of the RBI, which sometimes, exacerbates the larger picture of monetary management. Subsequently, the intended use of anti-inflationary policy measures (CRR & rate hikes) will be more as a result, rather than by design.
A closer look at the intervention data for April 2008 by the RBI reveals that the RBI has again intervened heavily in the forward exchange market in the month of April 2008. This has resulted in a liquidity injection of nearly Rs 172 billion. Given that, the total liquidity withdrawal by the RBI through CRR cuts earlier was Rs 275 billion, the net impact has already been squeezed to Rs 103 billion. Thus the stage is set for 0.25-0.5 basis points in CRR by the RBI in the forthcoming review in July, or perhaps much before that to just maintain status-quo and not to beat inflationary expectations.
Now, the other side of the story. The RBI penchant for swap transactions in the foreign exchange market is possibly because of the fact that it serves the objective of sterilsation activities so as to contain the growth in net foreign exchange assets. However, if the experiences of the East Asian countries is to be believed, the apex bank will be even hard pressed to ensure the success of such sterilisation.
A study by this author had estimated that only 73% of the forex assets were offset by a change in domestic credit over the decade ended 2004. Thus, all other things remaining unchanged, (and assuming continuity of this trend) for an inflow of capital, this means that there should be a concomitant increase in the monetary base. Interestingly, studies indicate that South Asian economies, like Indonesia had a sterilisation coefficient of -0.76, which is an indication of partial sterilisation. Thus, India seems also to have sterilised partially during this period.
There is another dilemma. Irrespective of sterilisation activities, the more important thing is the impact on the domestic interest rate. Models in economic literature suggest that the domestic interest rate is a function of domestic and international monetary conditions. International monetary conditions are in turn determined by capital mobility, such that higher is the mobility, the more is the importance of external factors. In a similar vein, as capital mobility declines, the domestic interest rate is determined more by domestic monetary conditions.
Given that India has been the recipient of huge capital inflows in recent years, it is unlikely for the RBI to insulate the movement in interest rates from external factors.
I also object to the repeated swap transactions that the RBI has taken recourse to in recent months. Interestingly, this might be the sudden reason for the depreciation of the rupee against the dollar recently.
Releasing spot rupees into the system when the domestic currency is under pressure (remember the rupee was under pressure against the dollar from April onwards, because of slowing down capital flows) could just apply that much more pressure on the domestic currency. Banks that sell those spot dollars to the RBI will definitely not be running long rupee positions in a rupee-bearish environment. These in turn will be off-loaded on the market, generally accelerating the domestic currency?s slide.
There are also objections to the unlimited intervention in the forward exchange market in economic literature. As a typical example, consider an imaginary case where the current pressure on the exchange rate is expected to continue for more than three months (say, a year).
During the first three months, the authorities can generally succeed in offsetting the current pressure on the forward and spot exchange rates by an appropriate amount of official sales of forward exchange. If the same pressure continues after three months, however, the authorities would have to double their intervention effort in order to achieve the same result; for they must at the same time offset the adverse pressure shifted from the first three months to the current period. In a similar vein the authorities would have to treble the intervention in the third quarter and the piling up of forward commitments would always proceed faster than the lessening of the decline of reserves brought about by intervention, and hence the problem would only get complicated.
Finally, a reality check. The apex bank has been trying hard to beat inflationary expectations through rate hikes also (take the recent repo rate hike). But let me forewarn you. The interest rates offered by the banks are unlikely to see any significant downward revisions from the current levels, even if the situation so warranted, given that Indian banks now have a significant exposure to retail segment. This is because, official studies suggest that retail lending posing various risks, having adverse implications for banks? asset quality.
Really, the RBI is caught between devil (inflation) and the deep sea (monetary management). My only suggestion to the apex bank is not to bother about too many objectives at this point of time (say, exchange rate management), but rather concentrate on only price stability.
The author is a director with a leading MNC. These are his personal views