The RBI should indicate what it will do in the credit policy and not leave everybody guessing. One of the biggest difficulties for RBI in keeping interest rates high is the inflow of capital that it invites. Despite efforts at bringing back capital controls, capital flows through ECBs and other channels have flourished. A key factor driving this is the cut in interest rates in the US and Europe, which has widened the interest differential with India. It is, therefore, not surprising that in spite of ECB curbs, August 2007 saw $1.5 billion, September saw $2.2 billion and October saw $3.6 billion come in as such borrowings. All the curbs have done is reduce the number of companies borrowing abroad, with the borrowed sums still large. In June, before the restrictions, 88 companies borrowed a total of $2.8 billion. In October, two months after the restrictions, 30 companies borrowed $3.6 billion. The average loan has gone up, and the system has become biased against smaller companies, which, on global evidence, is a typical effect of capital controls.
Even otherwise, such curbs cannot do the trick. ECBs between April and October amounted to only $19 billion. But foreign currency assets with the RBI increased by $53 billion over this period. As long as the interest differential remains high, capital will continue to gush in. This would not have been a problem had the RBI not bought dollars on a massive scale in implementing its currency policy. But since it does so, it increases liquidity and creates inflationary pressures which then strengthens the logic for keeping interest rates high. This creates a vicious cycle in which the RBI keeps on increasing interest rates and then buying up dollars. Sterilisation of its intervention reinforces higher interest rateswhen the RBI auctions government bonds to mop up liquidity in the system, it puts upward pressure on interest rates, which, in turn, invites more capital.
Many banks have reduced their deposit rates since April, even though the RBI did not cut the repo or reverse repo rates that act as signals for the banking system to move rates (in fact, the CRR was raised, a tightening measure). This has happened because of the downward pressure that higher liquidity in money markets has put on interest rates. So even though, de jure, the RBI had a policy of not reducing rates to combat inflationary pressures, the increase in liquidity meant that de facto monetary policy was much looser than stated. Despite no change in policy rates, or any cut in CRR, bank deposit rates have come down since July.
Advance tax payments have tightened liquidity in the last few weeks, but as soon as this pressure goes away, we are likely to be back to the old game of RBI intervention raising liquidity beyond its sterilisation capacity. This would anyway put downward pressure on interest rates, which will encourage banks to lower deposit rates further. But the reverse repo acts at 6% as the lower bound of the interest rate corridor. This, therefore, needs to be cut. However, to go back to an interest corridor of 100 basis points, as in the original Laf framework, the RBI needs to cut the repo rate, currently at 7.75%, as well. Now that concern about high credit growth has abated with the decline in credit growth, this is not a difficult choice as it was until a few months ago.
In text book macroeconomics, when a central bank faces inflationary expectations, it must raise interest rates. However, in the case of an open capital account, this works only when the exchange rate is flexible. If the central bank tries to manipulate the exchange rate, higher interest rates actually end up being inflationary. The illusion that we can control capital flows while maintaining high interest differentials has been negated by data for 2007, where capital flows have not been blocked by capital controls. The illusion that all inflows can be sterilised if there is a blank cheque for MSS bonds has been negated by the pressure that MSS auctions have put on interest rates. If the RBI will not let the exchange rate be market determined, it has to cut interest rates. The impossible trinity demands that if India has an open capital account, and insists on exchange rate pegging, then its autonomy of monetary policy has to be given up.
Ila Patnaik is senior fellow at National Institute of Public Finance and Policy. These are her personal views