In the recent period, the Government has unleashed a slew of reform measures to energise the growth process. It is commendable that despite political economy problems, the government has gone ahead with bold measures.

Finance Minister P. Chidambaram has called for the Reserve Bank of India (RBI) to march in step with the Government.

More explicitly, the RBI, in its October 30 Monetary Policy Review, is expected to cut policy interest rates and ease liquidity. At the top of the Finance Minister’s wish-list is stability of the exchange rate — ‘stability’ unequivocally implying an appreciation of the rupee.

Policy Coordination

About 40 ago, Governor L. K. Jha, summed up the role of monetary policy: “Someone has jammed the accelerator (the fisc) and my job is to slam the brakes as hard as I can.”

Again, 20 years ago, in 1991, the Government unleashed a slew of reforms — removal of industrial licensing, liberalisation of foreign investment and correction of the fisc.

The RBI undertook a massive tightening of monetary policy in April, May, July and October 1991, using all the tools at its command — raising interest rates, increasing reserve requirements and a battery of strong credit controls.

More importantly, in July 1991, the central bank undertook a quick two-step devaluation of the rupee. While the situation in 2012 is certainly not a repeat of the 1991 crisis, it bears emphasising that in 2011-12, the balance of payments current account deficit (CAD) was 4.2 per cent of GDP and the Consumer Price Index (CPI) has been stubbornly close to 10 per cent per annum.

One does not tire of reiterating that the actual inflation at the ground level is significantly higher than indicated by the index.

Easing monetary policy by cutting policy interest rates, and releasing liquidity by reducing the cash reserve ratio (CRR), is a sure way of fuelling inflation. Rupee appreciation will only encourage imports, discourage exports and further widen an already high CAD.

Rupee appreciation

First principles indicate that a country with a higher inflation rate than major trading partners and running a large CAD has to depreciate its currency. When we appreciate the rupee against fundamentals, the foreign investor, who in June 2012 got Rs 57 per dollar, now gets a little less than Rs 53. Since the appreciation is against fundamentals, a depreciation in the ensuing period is inevitable and the foreign investor will have to down more rupees to remit out a dollar.

As such, the initial appreciation would be of some anxiety to foreign investors.

It is true that the government subsidy on petroleum will come down with appreciation of the rupee, but the demand for petroleum would go up. As such, appreciation of the rupee would be an imprudent policy.

Monetary Relaxation

Marching in step really means that the RBI should focus strongly on inflation control. Generalised inflation is, and always is, a monetary phenomenon and to break the inflationary spiral, monetary policy should be tightened.

Given the ground realities of the RBI-Government relationship, it would be unrealistic to expect the RBI to raise policy interest rates and tighten liquidity.

The duty of the RBI is to crush inflation and it should, therefore, fight a battle of attrition to avoid a relaxation of monetary policy on October 30.

Given the tremendous pressure on the RBI to relax monetary policy, it should, so to say, throw some sand in the machine — via administrative action -- to see that there is no effective relaxation.

Pulse of the Nation

The authorities would surely be able to assess the pulse of the nation.

The masses are seething with anger at the continuing erosion of their already low purchasing power. It is dangerous to sacrifice inflation at the altar of growth.

Sound bytes indicate that the authorities are contemplating inflation-indexed bonds.

The very limited information coming out seems to indicate that if the reference interest rate is, say, 6 per cent and the inflation rate is 10 per cent, the principal amount of Rs 100 would be increased to 110 and, on the face value of Rs 100, the investor will earn a nominal interest of Rs 6.60.

This is clearly not satisfactory and such an indexed bond would fail. It would be best to give a very low real rate of interest and provide for a nominal rate of the real rate plus the inflation rate.

Let us assume that the real rate is zero. With an inflation rate of 10 per cent, the principal amount of Rs 100 would increase to Rs 110 and the nominal interest rate would be 10 per cent.

Half-hearted inflation indexed bonds would be reflective of tokenism and would reduce the credibility of the inflation fighting commitment of the authorities.

The meaning and significance of RBI marching together with the government is that the former takes charge of two flanks — inflation control and a sustainable exchange rate.

(The author is an economist. blfeedback@thehindu.co.in )

Related Topics