Tuesday, February 05, 2008

Wrong call by RBI

I wrote an article in Business Standard today titled Wrong call by RBI on the subject of exchange rate pegging, interest rate differentials and the recent monetary policy (non) announcement by RBI.

In recent quarters, roughly 10-15% of GDP has come in by way of net capital flows. The true capital flows into the country are larger than this, owing to capital flows that are implemented over the current account. Hence, it's reasonable to think that RBI will be forced to add $100 billion to reserves (which is less than 10% of GDP) if the present policy framework continues. My rough calculations (in the article) suggest that this involves gifting Rs.20,000 crore to the private sector. This is money that is being paid for by the common man, since the fiscal costs of sterilisation are being placed on the exchequer. This seems like an inappropriate thing to do.

My main point is that there's a huge arbitrage opportunity out there. Hence, a tonne of money will come in. Hence, monetary policy distortions will build up with a pegged exchange rate. Hence, RBI will be forced to either break the peg, or lower rates, or both.

  • Why can countries like the UK or Israel hold rates while the US has cut rates? They don't run pegged exchange rates, and are hence blessed with a central bank that can think about what is right for them.
  • Isn't inflation a concern, justifying high interest rates? Whether inflation is too high or too low, we are powerless to use monetary policy to deal with it once we have pegged the exchange rate.
  • Doesn't this arbitrage fizzle out once RBI permits an INR appreciation and/or cuts rates? Yes, it does, but note that the long-INR + long-bond position gets an exit bonus when RBI does move. If RBI does nothing, there is a one way bet. But the profits to the position are accentuated to the extent that the INR appreciates and/or interest rates go down.
  • Shouldn't we focus on the rate at which corporations can borrow and lend, rather than interest rates on government bonds, when discussing the interest rate differential? Yes, the true size of the arbitrage opportunity is the difference between the borrowing rates abroad for USD-denominated borrowing by an Indian firm against the returns available by deploying that money in India. That differential happens to be bigger than 5.3 percentage points - so this actually strengthens my case. However, from the viewpoint of monetary policy, what RBI can control is only the policy rate; it doesn't control credit spreads. Hence, the discussion is couched in terms of the policy rate.
  • Isn't the Indian business cycle different from that in the US, meriting a different stance of monetary policy when compared with the US? Even if it is, once we peg the exchange rate, we have given away the ability to do monetary policy based on domestic considerations.
  • Why do you say that the interest rate differential needs to be no worse than 2 percentage points? Where is that number `2' coming from? India has been rapidly opening up to the world; openness is higher than ever before. And, we're right now running a tight INR/USD pegged rate with the price moving between Rs.39 and Rs.40. With high openness (by historical standards) and low currency flexibility (by historical standards), the interest rate differential must be low (by historical standards). Look at the graph, and the number of 2 suggests itself. If India were fully open, then running a pegged rate would require an interest rate differential of zero.
  • Is it wise for India to peg the exchange rate? No, it isn't, but now that we are running a pegged exchange rate regime, we have to deal with the consequences. It seems nice to peg the rate when focusing on the interests of exporters. But in the process, the larger interests of the economy get hurt.

For the backdrop to this, see the recent credit policy statement, in particular their call for capital controls:

95. In the context of a more open capital account and the size of inflows currently, public policy preference for a hierarchy of capital flows with a priority for more stable components could necessitate a more holistic approach, combining sectoral regulations with broader measures to enhance the quality of flows and make the source of flows transparent. In this context, it is critical for public policy to effectively, demonstrably and convincingly indicate commitment to managing capital flows consistent with macro fundamentals through appropriate and decisive policy actions.

And, in an interview, Y. V. Reddy said:

The US rate cut is a relevant input for monetary policy, but domestic issues predominate. Moreover, when you talk of an interest rate differential, which is the currency where you measure the difference. Since maximum carry trade was in the Japanese Yen the argument has to be in respect of Japanese Yen where there has been no change in rates. For us, domestic policy considerations dominate. In the US they are facing a slowdown but we are only seeing moderation from 8% to 8.5%. US is pumping liquidity into the markets, we are absorbing liquidity. For leading institutions in the US, profitability is under question, here banking profitability is good. We can have a convergence of a solution only when there is a convergence of the problem. I will be surprised if there is a uni-directional movement in policy rates across all countries.

If you go back and look at history, there have been occasions when we had a huge interest rate differential and we had outflows instead of inflows. US rate changes are an important but not a determining factor. It is also exchange rate expectations, view on fundamentals and there are several other factors operating. On one hand, we have to give weightage to that rate of interest that offers an optimum balance between savings and investment.

On the other hand, there is the interest rate differential. For which should you give more weight? At this point, I would repeat domestic considerations have to dominate to maintain a balance between savings and investment in India.

Finally, see these materials by Ila Patnaik: link, link and link. Update: Ila offers a big picture on the difficulties that motivate RBI reform.


  1. Dear Sir,
    As a layman, I think what Reddy has done is right. Before seeing the inflationary trends after passing on the fuel price hike, how do you lower interest rates. If inflation maintains a decent level of <4%, then, he can decide to lower rates by a full percent atonce. As to borrowing funds from abroad by corporates, there are ecb guidelines in place, and as and when it reaches dangerous levels they can act upon it to manage the situation.

    Admit my views are quite amateur without covering all areas of macroeconomics.


  2. I think for a central bank, inflationary concerns dominates the most. It is in this respect, that lowering of interest rates does sound a dangerous proposition. With regard to India letting go of a pegged exchange rate so as to have monetary policy autonomy, we really do not have an option as a pegged exchange rate is absolutely essential to maintain our export competitiveness. Wouldn't it be impractical to think of letting the rupee appreciate more and choking our export industries?


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