The stance that the RBI should take in its July 30 Monetary Policy Review Statement is being hotly debated. Popular opinion seems to be that with the rupee is refusing to be coaxed or coerced into behaving itself, the RBI is left with little option but resort to a tight monetary policy. However, it appears to be a case of missing the woods for the trees.
Two specific issues come to mind. First, a the myopic concentration on global factors to the exclusion of the role of the Government. Second, a misplaced focus of relying on on a single instrument — short-term interest rates — to achieve multiple (and mutually conflicting) objectives, namely, growth, price stability and exchange rates. As long as these twin issues remain unresolved, the RBI may well continue with its ‘costly gamble’.
The falling exchange rate has been attributed to lower dollar supply in the market relative to its demand, with the likely tapering of quantitative easing stated as the single-most important cause for the same.
Excess liquidity
Other factors responsible for the dollar demand-supply mismatch in the market have been identified as: the increasing current account deficit, net outflow of FII investments and a reduction in FDI flows. But what about excess rupee liquidity as a determinant of exchange rate? What has been the contribution of the Government’s fiscal activities towards excess rupee liquidity?
An important contributor to the volatile rupee has been the Centre’s Ways and Means Advances ( see table ).
The RBI, through a series of measures — hiking marginal standing facility (MSF), Open Market Operations and hiking liquidity adjustment facility (LAF) to Rs 75,000 crore — has tried to arrest the rupee volatility by targeting liquidity in the system. What has been the reaction of the money and bond markets to these measures?
Bond issue failure
The overnight segment rate has, in fact, marginally decreased despite these measures. The Rs 12,000-crore worth Open Market Operations for sucking out liquidity from the system were only partially successful (to the extent of Rs 2,500 crore) on account of high yield bids.
Similarly, T-Bill auctions worth Rs 1,900 crore, as also part of the Government’s market borrowing programme through Rs 15,000 crore of bond auctions, also witnessed high yields being demanded. The RBI — the Government’s debt manager — refused the high yield bids, resulting in a total rejection of the former and a Rs 3,526 crore devolvement on the primary dealers in the case of the latter.
What explains the inefficacy of the monetary tightening measures? Given that the Centre’s deficit at 4.8 per cent of GDP for 2013-14 (Budgetary Estimate) is Rs 542,499 crore, and with much of this borrowing still to happen in the fiscal year 2013-14, there is little wonder that the bond market is reacting in the given manner.
A fiscally profligate government cannot be protected by a debt manager on a long-term sustainable basis. Monetary tightening will, through higher government bond yields, only increase the actual fiscal and revenue deficit figures for 2013-14.
It remains a moot question whether such high yields will translate into higher FII inflows, given the expected US Government yield increases, or even whether they are desirable.
EXCHANGE RATE STABILITY
The RBI’s current focus is on exchange rate stability at the cost of the growth. However, given that fiscal mismanagement lies at the root of the exchange rate volatility and the latter’s implication for growth as well, we would be better off setting our domestic house in order.
There is no way we can achieve an 8-9 per cent growth rate with the current level of domestic financial savings.
What is the way forward? We recommend a status quo to be maintained vis-a-vis policy rates in the July 30 Monetary Policy Review. Any changes in policy rates would only address the aggregate demand side.
As has been clearly enunciated above, the problem has its roots on the fiscal side, with monetary policy being expected to clean up what essentially is a fiscal mess.
The onus to achieve the growth objective by augmenting financial savings also rests with the financial sector.
With wrong diagnosis come wrong policy prescriptions. It is important that the Government’s role in the entire exchange rate volatility be well understood. While the RBI attempts to tighten liquidity, the Government continues to infuse volatility in the liquidity through poor cash management.
The fiscal deficit figures for the remaining part of 2013-14 and the higher yields on government bonds as a result of monetary tightening measures will only add to the domestic factors responsible for the current macroeconomic imbroglio.
Is the RBI barking up the wrong tree, when it is trying to contain the rupee depreciation through monetary tightening? Our hunch is, it is.
(The authors are professors at the SP Jain Institute of Management and Research, Mumbai.)