Is RBI scuttling its own inflation fighting efforts?

- Orbis Economics editors

The RBI and the government have been playing a polite blame game for some time now, given the sad present state of the Indian economy. Growth has slowed down to recessionary lows, while inflation remains high, investments into the economy have dried up as has foreign demand. As a result, not only is the domestic economy suffering, the external sector is also somewhat uncomfortable, with FII inflows remaining unpredictable.

While the government often urges the RBI to start slashing policy interest rates, in order to re-energise the credit and investment cycle in the economy; the RBI on its part tosses the ball back in the government's court, alleging that a high fiscal deficit is to be blamed for high inflation and high interest rates and till such time that the centre does not trim its expenditure, high interest rates cannot be helped.

So far, there has been some progress on the fiscal front, with the government rationalising some prices of fuel, though given the overall expenditure and trends it is clear as it can be that the fiscal deficit target is unlikely to be met, unless some serious cutbacks are done over the remaining part of the year.

But, an Opinion piece by Arvind Panagariya, Professor at Columbia University, in the Economic Times today, argues that the RBI's own exchange rate policies have scuttled the inflation fire-fighting ship. Titled "Till the RBI manages its dollar war chest effectively, its focus on inflation will not yield results"; the article offers a fresh take on what is now an ongoing debate on which a number of economists have given their views. Typically these views agree with the RBI that the fiscal deficit needs to be managed better, particularly as it makes India less positively viewed as an investment destination. A number of these economists are also in the financial services sector, which makes the view understandable.

Panagariya, however, focuses on not the domestic aspect of the economy, but the external sector, which has been poorly managed according to him leading to a vulnerability. He says:

"Ironically, the RBI has had at best partial success even in combating inflation due to its poor management in another key area: the external sector. After India adopted the flexible exchange rates in the early 1990s, the long-standing practice of the RBI had been to intervene in the foreign-exchange market to smoothen out short-run fluctuations while leaning against excessive appreciation of the rupee in the longer term. That policy stance provided short-run exchange-rate stability while allowing the RBI to build up substantial foreign-exchange reserves over the years.

But some time around 2009, perhaps responding to the US criticisms of the Chinese interventionism, the RBI decided to be a 'good boy' and adopted a hands-off policy in the foreign-exchange market. When the rupee began appreciating even in nominal terms in 2009-10, it chose not to buy dollars to soften the rise, thus forgoing the opportunity to beef up its dollar war chest that would aid in combating future depreciation of the rupee.

Simultaneously, the RBI progressively eased the restrictions on external commercial borrowing to 'buy off' the corporate lobbies. While small and medium firms struggled to borrow at extra high domestic interest rates, liberalised external commercial borrowing gave corporations access to low interest rates abroad.

But these policies have not been without consequences for the RBI and the economy. The gross external debt rapidly climbed from $224 billion at the end of 2008-09 to $346 billion at the end of 2011-12. This debt significantly exceeded the foreign exchange reserves of $294 billion at the same time. Rising external debt and the failure to accumulate dollars in good times have left the RBI vulnerable on the external front."

Indeed, there is no doubt that the RBI has been relaxing ECB norms even till very recently and over a period of time as evident here, here and here. There might also be some justifications for it - given the critical need for investments in the infrastructure sector, for instance. However, rising ECBs also make exchange rate intervention a challenge as the RBI has to keep its forex reserves stocked up.

Whether or not intervening in a depreciating rupee market is necessarily desirable or not, is a separate debate altogether, as I argue here. In fact the RBI can counter argue that by keeping the rupee depreciated, exports can benefit and at a time when oil prices have been relatively stable, there is little net impact of a currency depreciation on India's oil bill. How the positive impact of a weak currency on the current account plays against the current challenge to the capital account is something that remains to be seen.

While at less recessionary times the argument holds weight, the fact is that despite a weak rupee India's exports have been contracting - likely on account of the Euro Zone crisis which is India's biggest trading partner. At a time like this, then, Panagariya's perspective raises the question - is this the best time for an ECB policy relaxation? While the RBI's official interest rate policy stance is duly noted with much interest on a regular basis, it might just be time to look more closely at unannounced policies too.