One of the most important policy changes witnessed in the last three years, but one that is routinely glossed over, is RBI?s move to make the rupee a largely floating exchange rate. In contrast to the heavy intervention witnessed earlier, the current regime at RBI has remained largely hands-off and let the market determine the rupee?s fair value. This was evident in the fact that the rupee depreciated more than 20% last year as global risk aversion spiked and has bounced back 8% into 2012 as risk aversion abates. RBI has admittedly intervened in the foreign exchange market over the last few months, but the level of intervention has been small compared to that of other Asian central banks, the size of reserves and the size of the foreign exchange market. Therefore, for all practical purposes, the rupee is a floating exchange rate.
Why is this important? While the sharp gyrations of the rupee may have unnerved corporates, the move to a float is a clear acknowledgment by RBI of the trilemma (or impossible trinity) of macroeconomics (a path breaking contribution by Nobel laureate Robert Mundell) that an economy cannot
simultaneously observe an open capital account, a fixed exchange rate and an independent monetary policy. The logic is straightforward. If an emerging market were to fix its
exchange rate, and then engage in a monetary stance different from developed markets (hike rates when developed markets are easing, for example), capital flows would move swiftly and sharply to take advantage of the interest rate differential and thereby undermine the original monetary stance of the emerging market (by forcing an accumulation of foreign currency reserves and creation of base money that undermines the original tightening). Conversely, if an emerging market were to unilaterally cut interest rates, a large capital outflow would result, draining reserves and making the fixed exchange rate untenable. Countries that have tried
to have their cake and eat it too, over any length of time, have ended in tears. Just ask the Thai authorities about 1997.
In light of this, RBI must be commended to moving to a floating exchange rate. If India is to grow at 8-9%?critical to creating employment opportunities for an increasingly young population?India will remain a structurally current-account deficit (CAD) country in the foreseeable future, with domestic investment exceeding domestic savings. We will therefore always be reliant on foreign savings. Abandoning capital account convertibility, therefore, was never an option. Maintaining an independent monetary policy is equally crucial to maintaining macroeconomic stability. As we have painfully found out over the last two years, domestic factors have been important drivers of inflation. So even as the Fed and ECB were easing policy through 2010 and 2011, RBI was forced to go the other way?hike rates 13 times! The need for an open-capital account and an independent monetary policy made the choice clear?clinging to a fixed exchange rate had to go. Moreover, a floating exchange rate regime is just the shock-absorber that a CAD country like India needs?an adverse global shock generates a depreciation that stimulates exports, depresses imports and reduces the current account deficit, precisely when it is hardest to attract capital flows.
Domestic corporates may find a volatile exchange rate inconvenient, but they need to hedge foreign exchange risks rather than demand that RBI provide an implicit hedge for all. So kudos to RBI.
However, having successfully negotiated one trilemma, we now find that recent events in Europe have given birth to another trilemma for central banks around the world. The contours of this new trilemma were laid out and analysed in an excellent research conference organised by RBI a fortnight ago. The issue is this: the 2008 crisis made clear that central banks cannot focus exclusively on price stability. Their mandate must broaden to include financial stability as well. If that wasn?t enough, events in Europe have demonstrated that monetary policy has become subordinate to fiscal policy (the much-touted ?fiscal dominance of monetary policy?) whereby the ECB has been forced to increase the size of its balance sheets to help make sovereign debt less unsustainable.
The problem again is that these three goals?price stability, financial stability, sovereign debt sustainability ?are simultaneously incongruous for a central bank. For example, a large expansion of the balance sheet through purchase of sovereign bonds, while making sovereign debt more sustainable and helping promote financial stability, imperils future price stability. Similarly, promoting price stability may involve tough decisions on liquidity and rates that could, in turn, imperil sovereign debt sustainability. You can simultaneously achieve two of these objectives. Not all three.
Given what?s at stake in Europe, the choices made by the ECB appear understandable. Sovereign debt unsustainability has reached such proportions that it is the fundamental driver of financial instability. Given the slack in these economies, it appears understandable that central banks would veer towards ignoring price stability for now. While the fiscal dominance of monetary policy is not optimal, there seems little other choice at the moment. These economics have boxed themselves into a corner where monetary policy is hostage to fiscal policy.
So what are the lessons for India from this new trilemma? It is well understood that large fiscal deficits have been India?s Achilles? heel?crowding out more productive private investment. In this environment, there is obvious pressure on RBI to monetise deficits and slippages through open market operations (OMOs) in the name of ensuring ?financial stability? by artificially depressing bond yields.
But RBI must fervently resist this pressure and temptation. Large scale OMOs may result in the twin objectives of achieving sovereign debt and financial stability, but they fundamentally imperil RBI?s fight against inflation by injecting more liquidity into the system. In theory, RBI could sterilise this operation by selling dollars, but that would run down reserves and imperil external stability.
There is a crucial difference between the Fed, ECB and RBI expanding their balance sheets. The former are doing so in economies with a lot of slack in factor markets and inflation below targets. We face a very different environment. Given the stubbornly high inflation pressures that we have faced (and, which, I contend have not gone away) any attempt by RBI to accommodate large government borrowing creates liquidity likely to fuel more inflationary pressures and expectations?the last thing this economy needs. More importantly, the more RBI accommodates government borrowing, the less the incentive for fiscal authorities to bring their house in order. Only a spike in bond yields will generate the right market signals for the government to tighten its belt. The longer RBI engages in OMOs, the more those price signals are being suppressed.
RBI has successfully navigated Mundell?s original trilemma. Now it must tread carefully to avoid getting entangled in a new trilemma. The goal of India?s central bank must be clear?focus on price and financial stability and avoid the fiscal dominance of monetary policy. If the fiscal authorities choose not to see the light, then let them face up to the market consequences of their actions. RBI should not feed the lion.
The author is India economist, JP Morgan