12/20/22, 4:32 PM
FINANCE
‘Foreign hand’ in monetary policy?
November 1, 2010, 10:59 AM IST
Mythili Bhusnurmath
Mythili is consulting editor,
ET Now
https://economictimes.indiatimes.com/blogs/Myth-n-Reality/foreign-hand-in-monetary-policy/?source=app&frmapp=yes
‘Foreign hand’ in monetary policy?
Mythili Bhusnurmath in Myth-n-Reality, Finance, ET
It is a first in independent India’s history. But for the first time, the Reserve Bank of India’s
(RBI’s ) half-year review of its monetary policy due tomorrow will have to be framed with
an eye more on the external , rather than the internal, factors. This is a sea change from
the past when our much lower level of integration with the global economy meant
domestic monetary policy could afford to be almost entirely inwardly-focused . Not any
longer!
Today, the impossible trinity that says that policymakers can choose only two out of the
three objectives of free capital mobility, monetary policy independence and exchange
rate stability is no longer a matter of only academic interest to policymakers in the RBI,
as in the pre-reform days. On the contrary . They know that with an increasingly open
capital account, monetary policy has to be oriented either towards an external objective
such as the exchange rate or an internal objective such as the price level, but cannot
achieve both at the same time.
In the past, India, like many emerging market economies, got out of that trilemma by
opting for an intermediate solution skewed more towards exchange rate stability and
monetary policy independence . But as capital controls, especially on inflows, have all
but vanished and quantitative easing (QE) continues unabated in the US and to a lesser
extent, the UK, we will have to decide: do we wish to reorder our priorities?
Are we prepared to accept more exchange rate volatility or do we wish to sacrifice
monetary policy independence ? Or, like many emerging markets, do we want to impose
capital controls? To be sure, the finance minister has repeatedly said he is not in favour
of such controls. Of course, he could always quote John Maynard Keynes who, when
accused of inconsistency famously retorted, ‘when the facts change, I change my mind,
what do you do, sir?’ and do an aboutturn. But for now, the RBI will have to live with a
government that does not seem to fully appreciate its concerns on capital flows.
We’ve already seen the consequences of this. The rupee has appreciated by little over
5% since September and asset markets are fast becoming overvalued . Morgan Stanley
estimates that during the last 12 months, capital inflows would have been in the range of
about $65-70 billion. If easy liquidity conditions persist, as seems likely, the present flood
of dollars into the country could become a deluge.
The implications for the rupee-dollar exchange rate and hence for monetary policy are
enormous. So far, most of the inflows were being absorbed by a high current account
deficit and by a modest (?) appreciation of the rupee. But there is a point beyond which
an appreciation of the rupee could begin to hurt exports.
To be sure, we have not seen that happen as yet. On the contrary, data released by the
government last Monday shows the September 2010 trade deficit (difference between
merchandise exports and imports) at a much more manageable $9.12 billion compared
with the August number of $13.06 billion. And though export growth continues to lag the
growth in imports, as is inevitable in a fast-growing economy, the gap has come down,
setting at rest fears that a rising rupee would spell a death-knell for exports and affect
employment adversely.
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12/20/22, 4:32 PM ‘Foreign hand’ in monetary policy?

IT WOULD be hasty, however, to infer from this that we can relax our vigil as the broad
trend till September has been a steady worsening of the current account deficit. Or to
conclude that the exchange rate has no impact on exports (the Chinese success has
been built almost entirely on an undervalued currency ). But what it does suggest is that
improving productivity has made the exchange rate less important than before . And
though this does ease the pressure on the RBI to intervene in the forex market to arrest
rupee appreciation (with all its attendant consequences on liquidity), the reality is,
dependence on large capital flows to finance the current account deficit could invite
trouble, especially when these flows are volatile.

All of which suggests the RBI needs to think through its policy options in response to
such flows, should they persist on the present scale. Foreign institutional flows have
already crossed $25 billion, the highest in a calendar year, and the momentum has
picked up since early October. How much more appreciation can we tolerate? If we’ve
taken as much ‘punishment’ as we can on the exchange front, can the RBI intervene to
buy dollars? What does that mean for liquidity management?

To the extent monetary conditions are much tighter now than earlier and the RBI, far from
absorbing liquidity, has been augmenting it, can it worry a little less about the impact of its
forex intervention on domestic liquidity? Especially now that there are signs of some
moderation in inflation in manufactured goods (food inflation is largely outside the
purview of monetary policy ) and the lagged impact of five policy rate hikes since March
2010 is yet to work its way through the system?

Agreed, there are signs of asset-price inflation with stocks and the residential real estate
market showing immoderately high rates of inflation. But this is better tackled by
tightening the prudential norms on banks’ exposures to these sectors as raising rates at
this juncture runs the risk of attracting even more volatile foreign capital into India. In
such a scenario , governor Subbarao is best advised to hold his horses for now. As Alice
told the Cheshire Cat in Lewis Carroll’s Alice in Wonderland, ‘There are more ways than
one to skin a cat!’

Post-script : If it is any consolation, it is not the RBI alone that is now compelled to take a
wider worldview while framing monetary policy. The rest of the world is also far more
interested in its policy stance as evidenced by the London Financial Times‘Beyond Brics’
feature inviting readers to pose questions to the RBI governor on his monetary policy
review. Even a few years ago, it would have been unthinkable for the FT to do an
exercise like this. Even if it had, it is doubtful anyone would have responded. But till
Wednesday evening , the paper had received seven queries, most focusing on, guess
what, the impact of western QE on India. Clearly, the wind now blows both ways.

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