## Friday, December 14, 2007

### What should you do when you're stuck with a pegged exchange rate

On 12th, SBI cut deposit rates by 25 bps. Many newspapers thought this was partly a response to the liquidity conditions that have shaped up after the rate cuts of the US Fed. When asked by reporters, Y. V. Reddy said that he does have monetary policy autonomy. An edit in Financial Express titled Rewrite the RBI Act interprets SBI's decisions as reflecting a loss of monetary policy autonomy in India.

In an excellent article in Indian Express today, Ila Patnaik makes an argument that runs roughly like this:

1. In the short term, the reforms to financial and monetary policy institutions that are required `to do the right thing' are not forthcoming. The present RBI leadership has repeatedly articulated a lack of interest in reform. In any case, even if there was an interest in reform, it would take time to do the institutional transformation of finance and monetary economics as described in the MIFC report.
2. In the short term, the political situation is unfavourable for exchange rate flexibility, particularly given the difficulties that exporters will face selling into a slowing world economy.
3. Hence, in the short term, we are stuck with a pegged exchange rate.
4. That leaves two choices: capital controls or loss of monetary policy autonomy.
5. Capital controls are ineffective; India has gone too far along the route of modernising the external sector, and the political appetite for draconian controls (that are required in order to be effective) is absent. In addition, capital controls represent a step backwards compared with where India has to go. When financial firms and markets are damaged by controls, it will take time and effort to rebuild these things to get back to where we were.
6. Hence, the best path forward in this trap that we are in is: To give up monetary policy autonomy, and cut rates.
7. That might not be such a bad idea given the growing gloom in the global economy; lower interest rates would boost consumption and investment, and thus offset some of the impact of slowing exports [link].

Also see this review of the difficulties of India's pegged exchange rate regime in The Economist.

#### 1 comment:

1. how do you take care of inflation then?

stable exchange rate means that you've to pump in rupees into the market. And then add a low interest rate to this.

Prices will go for a toss!

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