In a recently released report, the Reserve Bank of India mentioned that an appreciating currency will help contain imported inflationary pressures. This has given rise to a fervent debate as to whether the RBI is no longer able to handle the Impossible Trilemma. The Impossible Trilemma, an important paradigm of open economy macroeconomics, asserts that a country may not be able to stabilise the exchange rate, and conduct an independent monetary policy when it is financially integrated with the rest of the world.
Policymakers in all sophisticated economies face this trilemma, forcing them to make choices about which targets they are going to pursue. The RBI has tried to avoid these choices: It has tried to pursue all three objectives simultaneously in an especially aggressive manner since the pandemic struck. It has reduced its policy interest rate to negative levels in real terms. It has bought government securities to push down long-term interest rates. It has allowed large capital inflows, then intervened in the foreign exchange market to prevent the appreciation of the rupee. These actions are incompatible, and will eventually generate a serious policy dilemma.
Budget estimates of tax revenue for 2020-21 of Rs 16.3 lakh crore were already an ambitious target over the previous year’s revised estimates of Rs 15 lakh crore. It was based on a nominal GDP growth projection of 10% made before Covid-19 hit India.
One of the corners of the trilemma has to do with capital inflows. In the first few months of the pandemic and the associated lockdown, the Indian economy witnessed a net outflow of foreign portfolio investment (FPI). However, this trend has reversed in recent months, as policymakers in the developed world have adopted stimulative measures to revive their economies, creating excess liquidity in global financial markets.
Between June and August, Indian capital markets received a net FPI inflow of close to $10 billion as foreign investors returned to the stock market. In September so far, for the first time in the last six months, inflows into the debt market have turned positive. India also received close to $17 billion of foreign direct investment (FDI) during April-July. Capital has also been flowing to India in the form of external commercial borrowing (ECB) by Indian corporations.
At the same time, the combination of weak economic growth, lacklustre domestic demand, and low oil prices have shifted the current account balance from deficit into surplus. Imports have fallen more than exports suggesting that India is doing worse than its trading partners. These factors have changed the balance of supply and demand in the foreign exchange markets as a result of which the currency has begun to face appreciation pressures against the dollar.
This brings us to another corner of the trilemma — currency stability. In the face of rising appreciation pressure, the RBI has been actively intervening in the foreign exchange markets to prevent the rupee from strengthening further. It has been buying dollars both in the spot and in the forward markets. In May and June, RBI’s net dollar purchase in the spot market was to the tune of $14.4 billion. In June, its net purchase in the forward market was more than $4 billion. As a result of the RBI’s currency trading, India’s foreign exchange reserves have increased by around $80 billion since January, to reach an all-time high of $540 billion.
When the RBI buys dollars in the FX market, it sells rupees. This increases the domestic money supply and is therefore inflationary. In order to counter this inflationary pressure that is being generated by RBI’s FX interventions, the central bank will ideally sterilise its interventions. This entails the RBI selling government bonds to banks and in the process absorbing excess rupee liquidity from the system.
But the RBI has not been absorbing the liquidity created through dollar purchases, it has been adding to it by buying government securities through its open market operations and targeted liquidity injection programs such as the T-LTRO. In the last couple of months, some of these operations have been neutral, such as the Operation Twist programme wherein the RBI buys long-term government securities and sells short-term bonds in order to lower the yields on the longer end of the maturity spectrum. But in total, the net bond purchase by the RBI has been positive. This implies that instead of sterilising its FX operations, the RBI is adding further liquidity into the system through its bond market interventions. As a result, liquidity has soared, reaching as much as Rs 8 trillion at one point.
For the moment, this injection of liquidity may not get readily converted into broad money because the growth of credit to the private sector has been weak, depressing the money multiplier. But if the RBI continues to ignore the Impossible trilemma, it will eventually fail. There are two main ways this could happen: It might need to give up on its exchange rate objective, as the recently released report hints. Or it might need to give up on its inflation objective.
Both would be problematic. Exchange rate appreciation will further damage the already hard-hit export sector. But allowing high inflation is even more of a problem in a country where the RBI has committed to the public not to allow a repeat of what happened after the last global financial crisis, when inflation soared to double digits.
Already, the constraints of the trilemma have tightened. Retail inflation has now breached the upper limit of 6 per cent for more than three quarters. Core inflation has been rising and inflation expectations have jumped sharply. And while credit to the private sector remains depressed, credit to the government has been strong, implying that overall broad money is growing rapidly. The time for difficult decisions seems to be approaching.
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