Inflation-targeting has created an overvalued rupee which has hit Make-in-India and export competitiveness
India’s move to an inflation-targeting monetary policy regime at this time is not in its economic interest. In fact, RBI has been following inflation-targeting informally over the past year which has weakened economic growth and job prospects and increased economic and financial vulnerabilities, especially the downside risk to the rupee. With Consumer Price Index (CPI) inflation around 5% and core-CPI inflation (ex-food, ex-energy) contribution close to 2%, a 7.5% policy rate is unjustified. The overvalued rupee is serving RBI’s interest of keeping inflation low via cheaper imports. Meanwhile, this is lowering GDP growth by hurting exporters and domestic producers who are facing competition from artificially cheaper imports. There is an urgent need to lower policy rates significantly and manage currency depreciation to a competitive level for Make-in-India.
There is no conclusive empirical evidence that inflation-targeting countries have performed economically better than countries whose monetary policies don’t target inflation. From the time it was first introduced, in 1990, till 2008, both inflation-targeting and non-inflation targeting countries experienced reduced inflation and improvements in growth rates and in their volatility (Roger, S. “Inflation Targeting Turns 20”, Finance & Development, March 2010).
Additionally, several inflation-targeting countries such as Iceland were hit hard by the 2008-09 crises. Most large economies, viz. the United States, the European Monetary Union and China, do not follow inflation-targeting.
The pre-requisites for pursuing inflation-targeting are not in place in India. The monetary policy transmission mechanism is not clear—despite RBI’s two recent rate cuts, totalling 50 basis points, commercial banks did not respond by reducing their lending rates. In an inflation-targeting regime, policy should be formulated in the light of a forward assessment of inflationary pressures and inflation rate. However, food and fuel comprise 55% of the CPI in India, and both can be and are difficult to forecast with any measure of certainty—both can be very volatile for non-economic reasons (geo-politics, weather, etc.). In such a scenario, it is very difficult for RBI to predict the inflation path with much certainty—consequently, interest-rate setting is virtually like throwing darts at unknown targets, with a high risk of missing.
RBI has been unable to make reasonable inflation forecasts and has consequently made arbitrary policy rate changes outside of scheduled policy meetings. In its October 2014 Monetary Policy Report, inflation for the first quarter of 2015 was expected at around 8%. The actual inflation was slightly above 5%—a huge miss! It is impossible to imagine how relevant policy interest rate can be set when RBI’s forecast for just one to two quarters ahead is far from reality.
Further, RBI had policy rate meetings in early December 2014 and early February 2015, yet strangely did not change its monetary policy stance at these meetings. Instead, it chose to do so unannounced on January 15, 2015, and March 4, 2015, without convincing reasons or any major new information becoming available in the interim. The cut in March was ascribed to a completely inexplicable reason, of fiscal intent, rather than due consideration to actual worsening fiscal numbers.
The absence of fiscal dominance is a sine qua non for successful inflation-targeting regimes. Fiscal dominance had been, and continues to be, the bane of India’s economy. Increasing fiscal constraints with rising revenue and fiscal deficits while putting fiscal consolidation on the back-burner will eventually lead to monetary policy’s subservience to fiscal policy via money printing.
The rupee has risen by about 10% over the past year in real effective exchange rate terms and is now approaching the peak of July 2011, wiping out all gains in competitiveness after the sharp depreciation of the Indian rupee during the summer of 2013. Consequently, non-oil exports have virtually stagnated while non-oil, non-gold import growth was 8.3% in FY15 following a decline in FY14. This is a reflection of cheaper imports on account of the overvalued rupee that is impacting sales and profitability of domestic firms. Rupee appreciation has been aided by higher interest rates that have encouraged large capital inflows, particularly relatively volatile and fickle debt inflows.
Current RBI policy is hurting growth while not necessarily helping reduce inflation. Since late 2013, RBI has focused excessively on taming inflation by raising policy rates to an undesirably high rate. Inflation has since retreated, although mainly as a result of lower international oil and food prices, over which RBI has little control. This begs the question as to how much its policies have helped curb inflation, and at what cost to growth. RBI has failed to clarify and quantify the impact of its policy on major economic variables such as economic growth, fiscal revenues, firm revenues and non-performing loans.
Higher interest rates and overvalued exchange rate are contributing to a delay in India’s much anticipated economic revival by raising the cost of investments, reducing investment demand, lowering export growth and increasing cheaper imports that have captured market-share of domestic firms. The lower economic growth is evidenced by lower growth in almost all indicators—bank credit, fiscal revenues, overall industrial production, consumer durables, capital goods, cement and high-speed diesel.
The slower economic growth is impacting firm revenues and health. Firm revenue growth outlook remains subdued while the situation of indebted companies worsens with high interest rates. This, coupled with an over-valued rupee, will impinge on borrowers’ ability to repay interest and principal leading to increased non-performing loans for banks, thereby further worsening India’s financial health.
RBI needs to clearly quantify the impact of its high interest rates and uncompetitive real effective exchange rate policy on growth, employment, fiscal revenues resulting from lower growth, increased stress on firm balance sheets, and consequent increased stress on banks and non-bank financial companies. Until now, RBI has failed to do so in its monetary policy reports.
The author is co-founder of Marketnomix Research, an independent economics and marketsresearch firm. He has worked as an economist with the International Monetary Fund and as an economist/investment strategist with HSBC and BSI Bank as well as a Global Asset Allocator at BSI Bank