33 highlights
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The third paragraph and the fourth line of the release said this: “The recent appreciation of the rupee is working towards containing imported inflationary pressures
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When the value of the rupee appreciates against the dollar, the imports become cheaper.
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Let’s say the price of a product being imported into India is $10. If the dollar is worth Rs 76, it costs Rs 760. If the dollar is worth Rs 73, it costs Rs 730. Hence, if the rupee appreciates, imports become cheaper and in the process the inflation (or the rate of price rise) that we import from abroad, comes down as well.
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The trouble is that if imports become cheaper, things become difficult for the home-grown products. Hence, an appreciating rupee goes against the government’s pet idea of atmanirbhartha or producing goods locally.
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The RBI has basically hit the trilemma, something which it can’t admit to.
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Basically, a central bank cannot have free international movement of capital, a fixed exchange rate and an independent monetary policy, all at the same time. It can only choose two out of these three objectives.
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Monetary policy refers to the process of setting of interest rates in an economy, carried out by the central bank of the country.
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In this scenario, let’s say the central bank sets interest rates at a higher rate than the rates in the United States and other parts of the world. What will happen is given that reasonably free movement of capital is allowed money from other parts of the world will come flooding in to cash in on the higher interest.
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When the foreign capital comes into the country in the form of dollars and other currencies, it will have to be converted into the local currency. This will lead to the demand of the local currency going up and the local currency will appreciate against the dollar. Of course, when this happens, the value of the local currency will no longer remain fixed against the US dollar.
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This is where the trilemma comes to the fore. If the country wants monetary independence and free movement of capital, it cannot have a fixed exchange rate.
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The repo rate, or the rate at which the RBI lends to banks, was cut from 5.15% to 4%, in the aftermath of the covid-pandemic. The RBI has also flooded the financial system with money by buying government bonds.
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The idea was to drive down interest rates to lower levels, so that companies borrow and expand, people borrow and consume. In the process, the economy starts to recover.
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The RBI has also intervened in the currency markets trying to ensure that the rupee doesn’t appreciate against the dollar.
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In the aftermath of covid, Western central banks have gone on a money printing spree, some to drive down interest rates and to get businesses to expand and people to consume, and some others to finance the expenditure of their government.
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To cut a long story short, interest rates have been driven down globally and there is a lot of money going around looking for some extra return. Some of this money has been coming to the Indian stock market.
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The import of crude oil and petroleum products between April and August 2020 has fallen by 53.7% to $26.02 billion. This has been both on account of fall in price of oil as well as lower consumption.
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To prevent the rupee from appreciating against the dollar, the RBI buys dollars by selling rupees.
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By buying dollars, the RBI releases rupees into the Indian financial system and thus increases the money supply. In the normal scheme of things, the RBI can sterilise this by selling bonds and sucking out this money. But that would have gone against the easy money policy that the Indian central bank has been running through this financial year.
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The excess liquidity (or the money that the banks deposit with the RBI) in the financial system suggests that the RBI hasn’t really been sterilising the rupees it has put into the system to prevent the appreciation of the rupee.
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Food inflation has primarily been on account of supply chains breaking down thanks to the spread of the covid-pandemic.
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As per the RBI’s agreement with the government the inflation should be 4% within a band of +/- 2%.
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If we look at the core inflation (which leaves out food, fuel and light), it is at 5.16%.
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An IMF Working Paper titled Food Inflation in India: The Role for Monetary Policy suggests the same thing: “Food inflation [feeds] quickly into wages and core inflation.” This is something that the country saw in the five-year period before 2014, when food inflation seeped into overall inflation.
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As mentioned earlier, all the money that the RBI has pumped into the Indian financial system hasn’t led to an even higher inflation simply because the consumer demand has collapsed. But as the economy continues to open up and the demand picks up, there is bound to be some amount of excess money chasing the same amount of goods and services, leading to higher inflation.
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If RBI keeps trying to intervene in the foreign exchange market to prevent the appreciation of the rupee against the dollar, it will keep adding to the money supply and that creates the risk of even higher inflation.
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To counter this risk of higher inflation, the RBI will need to raise the repo rate or the interest rate at which it lends to banks.
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This goes against what the Indian economy or for that matter any economy, needs, when it is going through an economic contraction. This in a way suggests that the RBI has lost control over the monetary policy.
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When the RBI sells government bonds to carry out sterilisation, it sucks out excess rupees from the market. This might lead to interest rates going up.
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If interest rates go up more foreign money will come into India looking to earn that higher interest rate. And this will create the same problem all over again, with the demand for rupee going up and the RBI having to intervene in the foreign exchange market.
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What’s the RBI’s best strategy here? It can pray that foreign inflows slow down for a while, like they have in September.
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The RBI ended up in this position by abandoning its main goal of managing price inflation.
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Instead of managing inflation, the RBI chose its role as the debt manager of the government to outshine everything. This led to all the excess liquidity in the system so that interest rates were driven down and the government could borrow at lower interest rates
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As Rajan and Prasad put it: “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.”