Breathe easy when the rupee falls

Times of India, October 13, 2022

While the Indian economy has started recovering from the pandemic, the global economy has begun to decelerate. This has complicated the task of finding an appropriate policy mix that can deliver growth amidst multiple global headwinds. Existing domestic imbalances such as high inflation and a large stock of government debt have already imposed constraints on the authorities’ ability to manouver. Now the constraints are likely to worsen as India’s export prospects have dimmed and current account deficit seems set to widen. In such a situation, is there any policy space left to support growth? It seems there is a powerful arrow in the RBI’s quiver: the exchange rate.

There are widespread concerns about an impending recession in developed economies, as they struggle to deal with the worst streak of inflation in four decades. The US Fed has already raised its policy rate by 3 percentage points since March 2022, the most aggressive monetary contraction since the 1980s. It has now signalled that this tightening cycle will last longer than previously expected. The European Central Bank and the Bank of England have also embarked on monetary contraction in order to bring inflation down to their target levels of 2%.

As if this sudden shift in the monetary environment were not enough, Europe is currently facing an energy crisis as Russian supplies of natural gas dwindle, while China’s economy is dealing with an abrupt end to the real estate boom that had been powering that country’s economy for the past decade. Owing to these developments, the IMF has lowered its forecast of global growth for 2022 to only 3.2 percent, far below the 4.4 percent it predicted at the start of the year. As a spillover effect, already India’s pandemic-time export boom has ended. In fact, September 2022 witnessed a fall in exports, with declines being particularly sharp for apparel and engineering goods.

This situation has put domestic policymakers in a bind. Ideally, they would react to the fall in external demand by stimulating domestic demand. But the policy space available to do so is highly limited. The fiscal deficit in 2022-23 is budgeted to be around 6.4 percent of GDP and the debt to GDP ratio continues to be very high, close to 90 percent. This restricts the fiscal space available to the government to provide any kind of stimulus.

On the monetary side, the RBI has now begun tightening policy to bring inflation back to the target level. The RBI’s medium term inflation target is 4 percent, whereas the CPI inflation has been averaging at 6-7 percent in 2022 so far. While oil and commodity prices have been softening, erratic monsoon is pushing up food inflation leaving no room for the RBI to go easy on the rate hikes.

This implies that using fiscal or monetary policy to support growth at this juncture will only worsen the existing macro imbalances: the high levels of inflation, government debt, and the current account deficit (CAD).

The CAD is especially a problem now. On current trends it could reach the exceptionally high level of 4 percent of GDP in 2022-23. Such a high CAD would be very difficult to finance. In fact, capital is flowing the other way, with rising US interest rates encouraging investors to take money out of Indian capital markets and deploy it instead in the US.

Given the circumstances what can the RBI do? The most obvious strategy would be to try to bridge the gap between rising CAD and falling capital flows by using its foreign exchange reserves. Indeed, that is exactly what it has been doing. However, there are limits to what the RBI can or should do. Bridging this gap using reserves makes sense only if the gap is small and temporary. It has turned out to be neither.

Reserves have now been falling for an entire year, by a staggering $110 billion between September 2021 and early October 2022. The pace of reserve loss seems set to accelerate as India’s CAD widens and the US continues to increase interest rates.

Clearly, other strategies are needed. The RBI could try to stem capital outflows by raising rates to reduce the interest differential with the US. But given that the US Fed has signaled that it will increase rates by another 125 basis points (and might do more), this strategy might require much more aggressive rate hikes on the part of the RBI than what is warranted by domestic inflation. Such a strategy could end up hurting the nascent economic recovery even more.

That leaves the exchange rate. The RBI could allow the rupee to respond to market forces, and depreciate. Such a strategy would have a number of advantages. Most obviously, it would reduce the need to spend so much of the foreign exchange reserves; these can be preserved for situations when the country is faced with temporary and unforeseen external shocks, rather than chronic drains on the balance of payments.

A second advantage of allowing the rupee to depreciate is that it would enhance the competitiveness of Indian exports. This would be a powerful way – more powerful than targeted subsidy programs -- of ensuring that India would be able to gain some of the global market share that China has been giving up. And in doing so, it would ensure that exports, the key motor of India’s post-pandemic growth, does not seize up at such an early stage of the recovery.

Of course, a currency depreciation could add to the inflation problem, by increasing the rupee price of imported goods. But the effects would likely be minor, as long as monetary policy remains tight.

In other words, the benefits of this strategy are likely to far exceed the costs. The good news is that the RBI already seems to be on this path. After a period of trying to stabilise the currency, the RBI has recently allowed the rupee to depreciate. Rupee has reached an all-time low of nearly 83 against the dollar.

For the first time in several decades US inflation exceeds Indian inflation. Looking forward, as long as the Fed persists with rate hikes, there will be pressure on the rupee to depreciate. In response, the RBI should continue to let the rupee respond to market forces. This policy should be accompanied by appropriate government support, such as moving away from protectionist policies, and taking steps to create a more export-oriented environment so that firms can reap full advantage of a weaker rupee. These policy actions may in turn help turn the growth cycle around for India, and help cement its position as a fast-growing economy.

What the term premium is (or is not) telling us?

(with Harsh Vardhan) Bloomberg Quint, October 6, 2022

An important and usually reliable measure of the future economic outlook is the yield curve in the bond market. It is particularly useful when the overall economic environment is highly uncertain, such as now. The yield curve shows the yields of government securities (G-Secs) of various maturities. The steepness of the yield curve is often used as a proxy for market expectations about future interest rates, and hence future inflation and growth. In recent times however, the reliability of the yield curve and its information content have come into question.

One simple way to measure the steepness is the term premium. It is the difference between the yields at the short end and at the long end of the yield curve. In India, the long-term yield considered is typically the 10 year G-Sec yield while for the short-term, it is usually the yield on one-year treasury bills. Monetary policy has an important impact on the term premium. The actions of the central bank directly affect the short-term interest rate. The bond market interprets the central bank’s actions and statements and transacts long dated bonds setting the long-term rates.

Since May 2022, the RBI has been hiking the policy repo rate in response to the rise in CPI (consumer price index) inflation which averaged at 6.8% between January and August 2022. Accordingly the short-end of the yield curve has gone up from 5.1% in early May to 6.7% now. This is a move of around 160 basis points in the 1 year G-Sec yield.

The RBI has also been highlighting in its monetary policy statements the significant upside risks to inflation that remain a concern. It has specified that it will continue to withdraw surplus liquidity from the system which is consistent with a contractionary monetary policy. Its CPI inflation forecast for FY 2022-23 is 6.7%, much higher than its inflation target of 4%. This implies that monetary policy may need to be tightened in a calibrated manner for the next few quarters.

Moreover, monetary policy tightening in the US has led to a strengthening of the US dollar and accordingly an 11% depreciation in the rupee-dollar exchange rate in 2022 so far. This has been the fate of currencies across the world, not just in emerging economies, and has led to central banks raising interest rates in order to defend the exchange rates. There are talks among the analyst community in India that the RBI might follow suit. Given that the Fed has said it might increase interest rate by another 125 basis points by the end of 2022, any attempt to use monetary policy to defend the rupee’s value may require the RBI to raise rates significantly.

Given the circumstances, one might expect the yield curve to steepen i.e. long-term yields should go up alongside the short-term ones, reflecting market’s expectation of higher interest rates in the future.

What we see instead is that the rates at the long-end of the yield curve have gone up by only around 30 basis points – from 7.1% in early May to 7.4% now in comparison to the increase in the short end by about 160 bps. As a result, the term premium has come down to around 50-70 basis points from a long-term average of over 90 bps. This has led to a remarkable flattening of the yield curve which seems counterintuitive.

Such a flat yield curve implies that the bond market believes that the rate actions taken by the RBI would help control inflation, which in turn would lower the chances of future interest rate hikes. In other words, the market does not agree with the RBI as far as assessment of risks to inflation are concerned. It also means the market does not expect the RBI to raise rates to match the monetary policy tightening being undertaken by the US Fed.

If the long-term yields remain as steady as they have been over the last few months, and the RBI continues to tighten the short-term rates, we may soon see the term premium moving close to 0. For an economy growing roughly at 5-6% on average with an inherent inflationary impulse, such a flat yield curve implies that the market is anticipating a severe growth slowdown and hence monetary policy easing.

Is that indeed the case? The answer is: it is not possible to answer this anymore by looking at the yield curve. Let's understand why.

During the pandemic the RBI had expanded its balance sheet by around 25%. It bought long-term G-Secs and the 10Yyields were held steady around 6%. Since October 2021 it has stopped its bond buying program. At its peak the RBI’s balance sheet was around Rs 65 trillion in October 2021. Between then and September 2022 the balance sheet has shrunk marginally to around Rs 59-60 trillion. This means that while the RBI has been withdrawing short-term liquidity using the SDF and reverse repo facilities, it has not been selling long-term G-Secs.

Typically, the RBI withdraws long-term liquidity through open market operations (OMOs) or by selling dollars from its reserves. In the former case, the stock of G-Secs goes down, and in the latter, reserves fall. The RBI has lately been relying on the second mechanism - selling dollars - to reduce liquidity (and to stem the rupee depreciation). When the RBI’s GSec holdings were small, this did not matter. Now the RBI potentially holds around Rs 15 lakh crore worth of G-Secs which is tad below 20% of all outstanding G-Secs, compared to its peak holding of Rs 15.8 trillion in September 2021. In contrast, between 2011 and 2020, the average RBI ownership of G-Secs was roughly 11% of the outstanding. As long as the RBI continues to hold such a large amount of G-Secs, the long-end of the yield curve is unlikely to respond freely to economic conditions.

A natural way for the term premium to shrink is if inflation comes down or growth slows down. But if in some part of the market there are no transactions, and a large chunk of the supply of long-dated bonds is cornered then this hampers price discovery. All interest rate sensitive securities are directly or indirectly priced with reference to the yield curve. Any such distortion of the yield curve therefore will translate into an economy wide pricing distortion. This also hampers transmission of monetary policy along the yield curve.

The RBI itself has been advocating an “orderly evolution of the yield curve”, but its own decision has important consequences for the market in general and the yield curve in particular. The current compression of the term premium suggests that the yield curve is anything but orderly.

Playing it safe

Indian Express, August 5, 2022

The RBI's latest Financial Stability Report (FSR) has given the banking system a reasonably clean bill of health. It's a significant achievement, considering the stress of the previous decade, the shock of the pandemic and the associated slowdown of the economy. However, the improvement in banks' financials presents a glass half-full picture. It is still unclear whether the banking system is healthy enough to provide the sustained credit growth needed for a strong economic recovery.

Two key indicators demonstrate the banking system’s progress. Successive waves of recapitalization have given banks enough resources to write off most of their bad loans. As a result, they have been able to bring down their gross NPAs from 11 percent of total advances in 2017-18 to 5.9 percent in 2021-22. NPAs for industrial credit have been reduced even more dramatically, from 23 percent to 8.4 percent. Even after these large write-offs, most banks retain comfortable levels of capital.

This financial turnaround has given banks the space to resume their business of extending credit. During the decade when banks were under stress, non-food bank credit growth had been declining, reaching just 6 percent in 2020, its lowest point in six decades. Since then, credit growth has nearly doubled.

These are the visible signs of a healthier banking system. However, the broad aggregates conceal a worrisome picture, raising questions about the role bank credit will play in supporting GDP growth. The problem is that very little of this credit is going to large-scale industry or for financing investment.

Consider first the sectoral distribution of credit. Over the last decade, banks have increasingly shifted away from providing credit to industry, favouring instead lending to consumers. Consequently, the share of industry in total banking credit has declined from 43 percent in 2010 to 30 percent in 2020, while that of consumer loans has increased from 19 percent to 29 percent. This trend is continuing: in the year ending March 2022, consumer loans grew at 13 percent, whereas loans to industry grew at just 8 percent.

Bulk of the industry loans has been extended to the smaller firms (MSMEs), which benefitted from the credit guarantee scheme offered by the government in the wake of the pandemic. Loan growth for MSMEs went up from 3 percent in 2020 to 31 percent in 2022. In contrast, lending to large industries has been stagnant in nominal terms during the last two years, implying that it has declined sharply in real terms.

A related problem is that there has been little lending for private sector investment. Over the last one year, bank lending to infrastructure has grown by 9 percent, up from 3 percent in 2020, but this was fuelled mainly by public sector capital expenditure. Meanwhile, much of the lending to private industry has been in the form of working capital loans, necessitated by the increase in commodity prices, which has led to a sharp rise in the cost of holding inventories.

Why is there so little lending for investment by large firms? Both demand and supply side factors seem to be at work. On the demand side, private sector investment has been sluggish for nearly a decade. The boom-and-bust of the mid-2000s had saddled firms with excess capacity, giving them little reason to expand their production facilities. In addition, the Global Financial Crisis had shown the dangers of ambitious expansion supported by excessive borrowing, leading firms to conclude that it would be prudent to scale back their plans and instead focus on reducing their debts.

On the supply side, banks have learned similar lessons. During the period 2004-2009, rapid GDP growth in the Indian economy was fuelled by an unprecedented lending boom. Credit doubled within the span of a few years, primarily on the back of lending to large infrastructure projects. Subsequently, many of those loans turned bad, leading to high levels of NPAs on bank balance sheets. As a result of these financial problems, banks for a decade were unable to extend much in the way of credit. Even when their health improved, they remained wary of lending to large-scale industrial projects, preferring instead to shift to smaller-scale and less risky consumer lending. This situation of risk aversion on the part of firms and banks has not changed perceptibly during the post pandemic recovery.

On the positive side, firms seem to have finally used up much of their spare capacity. But on the negative side, the fundamental problems that led to the difficulties of the past decade still have not been resolved. There is still no framework that will reduce the risk of private sector investment in infrastructure, certainly not in the critical and highly troubled power sector. Nor is there any reassurance for the banks that if problems do develop, they can be resolved expeditiously, since the Insolvency and Bankruptcy Code (IBC) has been plagued by delays and other problems. Now, heightened global macroeconomic uncertainty, growing geopolitical tensions and uncertain recovery prospects of the domestic economy are likely to make matters worse.

In other words, a healthy balance sheet of the banking sector is a necessary but not a sufficient condition for economic growth. The important question is whether banks and firms will once again be willing to take on the risk of investment in industry and infrastructure. And this seems unlikely unless there are deep structural reforms – to the infrastructure framework, the resolution process, and indeed in the risk management processes at the banks themselves. In the event that these reforms do not materialise, there may continue to be shortfalls in credit, investment, and ultimately in economic recovery and growth.

Why weaker rupee isn't all bad news

Times of India, July 22, 2022

Over the last few months, the exchange rate has come under intense pressure, falling to nearly Rs. 80 to the dollar, its lowest level ever. Some observers have argued that this pressure can be managed easily, since the country can simply sell a portion of its foreign exchange war chest, which amounts to a healthy $580 billion. Unfortunately, currency management is not that simple. In fact, it is not obvious that dollar sales will be sufficient to resolve the exchange rate pressure – or even whether preventing depreciation is the right strategy for the economy at present.

Let’s start by considering why the rupee has been under so much pressure. A key reason is that the US Federal Reserve has begun to tighten monetary policy aggressively to control inflation, which is at a four-decade high. The Fed has already raised interest rates by 150 basis points so far this year and is expected to tighten by a further 75 basis points later this month. When the Fed raises interest rates, global investor funds shift their portfolio allocations towards US financial markets, taking the money out of other countries. In India’s case, the net sales of foreign portfolio investors have amounted to a sizeable $31 billion in 2022 so far, according to data from NSDL.

The inflow of money into the US has led to an appreciation of the dollar. The dollar index (DXY) has strengthened against its trading partners by more than 11 percent this calendar year, reaching levels last seen in 2002. The counterpart to this appreciation has been a depreciation of the pound sterling, the euro, and nearly all Emerging Market (EM) currencies. In the case of the rupee, the depreciation has amounted to a relatively modest 7 percent since January 2022.

In fact, the rupee’s depreciation has been surprisingly modest, considering that at the same time that capital has been flowing out of the country, India’s current account deficit (CAD) has also been widening. Typically, the CAD increases when aggregate demand grows so rapidly that imports rise faster than exports. However, aggregate demand in the Indian economy has been tepid since the onset of the Covid-19 pandemic and the recovery has been slow and gradual at best. So why is the CAD worsening?

Much of the answer lies in the rapid growth of import prices. India is heavily dependent on imports of petroleum (which cover 80 percent of the country’s needs) and other commodities. And supplies of commodities have been disrupted since the Russia-Ukraine war started in February 2022, causing the prices of petroleum, fertilisers, edible oils, and other products to soar. This has automatically inflated the import bill, pushing the monthly trade deficit to an all-time high of $26 billion in June 2022. On current trend, the CAD for the fiscal year could reach 3-3.5 percent of GDP.

This has put India in a difficult situation. Just when the country needs more financing to cover a widening CAD, capital has started to flow abroad. That is why the rupee has taken a tumble.

So what can be done?

Without doubt, India can utilise some of its ample foreign exchange reserves – and indeed, it has already done so. However, this is not a complete solution. When the central bank sells foreign reserves, commercial banks need to give rupees in return, draining them of liquidity. Consequently, when reserve sales become large, the liquidity drain becomes sizeable, potentially tightening the money supply far more than what is appropriate, thereby endangering economic recovery.

To address this problem, the foreign exchange intervention can be “sterilised” if the central bank buys government securities from the banks. In that case, banks will receive rupees, thereby replenishing their liquidity. But if the central bank purchases large amounts of bonds, this could push G-Sec rates down to inappropriately low levels, thereby endangering the inflation target.

For these reasons, there is a limit to the amount of foreign exchange that the central bank can sell without jeopardising its other targets. And there is a further problem: since investors know that there is a limit to the foreign exchange sales, they will be tempted to try to purchase as much as they can right now. In that way, a policy of foreign exchange sales can sometimes – paradoxically – increase the pressure on the exchange rate.

In view of the complications arising from the strategy of selling reserves, it might help to go back to fundamentals and ask a deeper question: do we really want to prevent the rupee from depreciating?

After all, if the rupee fails to follow when other EM currencies are depreciating, then India’s exports will lose competitiveness. Already, the rupee has appreciated significantly against other Asian currencies such as the South Korean won, the Thai baht and the Taiwanese dollar. If competitiveness is further eroded just when the global economic environment is turning difficult, export growth could really suffer. And that might be a big problem.

The two most important drivers of growth for an emerging economy like India are investment and exports. Private sector investment has been sluggish for several years. Last year’s recovery was highly dependent on exports, which fortunately grew exceptionally rapidly. If this engine of growth starts to sputter, so might the economic recovery.

Of course, there are costs to a weak rupee. In particular, depreciation will push up prices at a time when inflation is already a problem. But there are other mechanisms for addressing inflation, such as increases in the repo rate, which indeed are already happening. In contrast, there are no other ready mechanisms to safeguard export competitiveness, apart from the exchange rate.

In sum, reserves can indeed be used to stabilise the rupee – but only to a certain extent. And there are some important advantages to allowing the rupee to weaken, as a way of supporting India’s economic recovery process. Striking the right balance is going to be a challenge not only for India, but for all emerging economy central banks.

What the MPC says and what the RBI does

Indian Express, June 22, 2022

Communication is an critical element of monetary policy. In the current inflation targeting (IT) regime, the resolution adopted by the Monetary Policy Committee (MPC) and published on the Reserve Bank of India’s website on the day of the monetary policy meeting is an important channel of communication with the public. Yet there seems to be a gap between what the MPC says and what the RBI does.

Under the IT regime, the most important role in communication belongs to the MPC, consisting of three external members, three RBI representatives, and chaired by the Governor. By law, this is the highest monetary policy-making body in the land, tasked with deciding monetary policy changes at regular intervals. These changes are then communicated through formal statements, with the discussions underlying these decisions also being published, so that the public can understand why the MPC decided the way that they did.

During the first few years of IT from 2016 to 2018, the process worked quite well. On the days of policy announcements, the Governor and his deputies would participate in a press conference to answer questions from the media. But otherwise the focus was squarely on the MPC, especially its statement, from which the public used to glean important information about the monetary policy strategy – that is, why the repo rate was or was not changed.

From 2019 onwards, however, things began to change. The RBI began to release a separate Governor’s statement on the day of the monetary policy meeting, presenting an inflation outlook and even explaining the decision taken by the MPC. The rationale for this statement was unclear: at best, it has overlapped with the MPC statement; at times, it has seemed somewhat different, making it difficult for the public to understand what the policy strategy really was.

Consider the MPC statement following the June 8 Monetary Policy Review. The MPC highlighted inflation concerns, and voted in favour of raising the policy repo rate. On the same day, a Governor’s statement issued by the RBI mentioned that the central bank will also remain focussed on orderly completion of the government’s borrowing programme.

The issuance of two such different statements can lead to confusion, especially as lowering inflation and lowering government bond yields are contradictory policy objectives. This is an example of how over the past few years, a communication gap seems to have opened up between what the MPC has been saying and what the RBI has been doing, thereby potentially eroding credibility of the IT framework. This communication gap will need to be closed in order for the RBI to become successful in bringing inflation back to its 4 percent target level.

Why is communication so critical? There are many reasons. But let’s focus on just one, namely the ability of the central bank to influence inflation expectations. If the public believes the central bank is committed to keeping inflation under control, then it will act accordingly. Firms will moderate their price increases, fearing that large price rises will make them uncompetitive. Meanwhile, workers will accept moderate wage increases, while investors will accept low interest rates on their bond purchases. With everyone acting in this way, it will be easier for the central bank to ensure that inflation indeed remains low.

Of course, spikes in commodity prices will inevitably cause inflation to surge from time to time. But if inflation expectations are well anchored, then it becomes relatively easy for the central bank to ensure that inflation returns to the target level before too long.

The most important task of the MPC, enshrined in the RBI Act (Amended), 2016 that introduced IT, is to decide the repo rate, since this has long been the lynchpin of India’s monetary policy framework. Ever since the early 2000s, policy had aimed to keep overnight money market rates in a corridor, with the lower bound established by the reverse repo rate and the upper bound by the repo rate. Since the width of this corridor was fixed, once the repo rate was decided, the reverse repo rate was automatically determined, and market overnight rates adjusted accordingly.

But during the Covid19 pandemic, the RBI constantly adjusted the reverse repo rate even as the MPC kept the repo rate unchanged, meaning that the fixed width of the corridor was lost, and accordingly the MPC lost any role in determining interest rates. Accordingly, the remit of the MPC and indeed the credibility of the entire IT edifice was called into question.

In addition, the RBI introduced a number of new policy instruments, again outside the remit of the MPC. During the pandemic, it brought in the GSAP program through which the RBI precommited to buying a certain amount of dated government bonds in order to control their yields. It then introduced variable reverse repo auctions, and more recently replaced the reverse repo rate with the long-dormant standing deposit facility rate, the rationale for which was not explained in the MPC statement. Unlike developed country central banks like the Bank of England for example, all unconventional monetary policy announcements were kept outside the MPC statement thereby raising questions about the role of the committee in deciding monetary policy actions at a crucial time like the pandemic.

Lastly, the RBI has been intervening in the foreign exchange market to manage the rupee. Forex interventions by definition influence the domestic monetary base and inflation. Yet the MPC in its monetary policy statements does not discuss either the exchange rate dynamics or the forex interventions. Just as it does not discuss the RBI’s interventions in the bond market to lower the yields.

The net result of all these actions is a potential loss of both clarity and credibility. There appears to be an growing rift between what the MPC says and what the RBI does. And with the proliferation of policy instruments, it is no longer clear to the public how the policy stance should be measured – or what the monetary policy framework is.

In its latest two statements, the MPC indicated that policy would now be focusing on bringing India’s inflation rate under control. If the RBI is going to be successful in this endeavour, the first step must be to close the communication gap, by reintroducing a simple and clear policy framework and restoring the central role of the MPC.

Rating RBI’s rate hikes

Times of India, June 9, 2022

On June 8, the Reserve Bank of India increased the policy repo rate by 50 basis points. This is a step in the right direction. There is an ongoing inflation crisis in the country and the central bank seems to have finally woken up from its slumber. This however raises deeper questions about inflation control in India.

This is the second time in the last 15 years that India has faced an inflation crisis and the RBI has been caught napping. The first time was right after the 2008 Global Financial Crisis. One big difference between these two episodes is that the RBI is now an inflation targeting central bank. IT was implemented precisely to help avoid a situation of high and volatile inflation. So what went wrong, and what lessons can be learnt from the current crisis?

Let’s first understand how the RBI missed the inflation bus. The inflation problem has been brewing since 2020. During March-Dec 2020, CPI inflation exceeded the 6% upper limit of the RBI’s target band, for three quarters in a row. According to the RBI Act 1934 (amended 2016), this is considered a failure of the RBI to meet the inflation target. The RBI is required to write a report to the Central Government explaining the reasons for the failure, remedial actions to be taken and the estimated time period within which the target will be achieved. At the time however the RBI succeeded in dodging this accountability, citing data problems aggravated by the lockdown. This was also the time when the pandemic was in full swing and central banks all over the world were rolling out easy monetary policies. Hence the analysts and experts (barring a few) in India also did not question the RBI’s overlooking of the inflation problem.

Moving on to more recent times, the Russia-Ukraine war and persistent supply chain bottlenecks have once again pushed CPI inflation above the 6% level starting Jan 2022. More worrisome has been the persistent increase in WPI inflation which has steadily gone up from 10.7% in April 2021 to 15% in April 2022, the highest level in three decades. Wholesale inflation impacts retail prices with a lag. This implies that CPI inflation will continue to increase.

The table below summarises the RBI’s response to this surge in inflation. Even as CPI inflation kept rising and WPI inflation reached alarming levels, the RBI continued to underestimate inflation. It stuck to an accommodative stance and refrained from increasing the policy repo rate. This shows that the RBI did not consider inflation a serious problem till May 2022. Even though no new information surfaced between April and June, the RBI increased interest rates by a steep 90 basis points in a little more than a month, between May 4 and June 8.

This shows that the RBI was behind the curve and is now trying to overcompensate. This does not instill confidence about how inflation is being managed despite RBI being an inflation targeting central bank.

This episode raises deeper questions about the working of the IT framework and highlights some important lessons.

First of all, in the IT regime, the Monetary Policy Committee is responsible for forecasting inflation, setting the policy rate as well as deciding the monetary policy stance to help keep inflation within the target band. We need to ask why did the MPC fail in anticipating the surge in inflation months ahead of time and what reforms are required to help avoid a similar situation going forward.

Secondly, and a related point, it seems the MPC is not using the power that it has been vested with by the law. For instance, a critical feature of an effective committee is dissent by its members. This reflects diversity of opinions, one of the main reasons we have a committee now looking into inflation. It is remarkable that despite the uncertainty of the underlying macro environment, there has not been a single dissent in the MPC as regards the policy rate, for several months. Lack of disagreement raises questions about the MPC’s efficacy.

Third, the greatest contribution that monetary policy can make is inflation control. For this to happen, all other objectives of the RBI must be delegitimised, including, ensuring low-cost borrowing for the government, and exchange rate management.

Finally, a key element of IT is accountability. We need to create an environment where it is costly for the RBI to stray from its primary objective of inflation control. For example, when CPI inflation exceeds 6% for three quarters in a row in 2022, the RBI must explain where it went wrong and what steps are being taken to remedy the situation.

In India, inflation harms the poor the most, and hence it is directly relevant for politicians trying to win elections. In such a situation, the best thing that the RBI can do is to deliver a predictable 4 per cent CPI inflation for decades so that economic policymaking can get back on track and firms and households can start planning for the future. Both the RBI and the government must therefore learn from the current inflation crisis and further strengthen the IT framework so that India does not face a similar episode of high and volatile inflation, the third time around.

Price of wrong price strategy

Times of India, June 2, 2022

India is now facing a dual problem of low growth and high inflation. The recovery has proved much weaker than expected, with growth amounting to a meagre 4.1 percent in the fourth quarter of 2021-22. At the same time, inflation has been surging so much so that over the past few weeks the government has taken a wide range of measures to deal with it. Unfortunately, this strategy is misplaced. The government’s actions will have only a marginal effect on inflation, while they may do significant damage to the incipient recovery. The government needs to step back from the inflation fight, and instead encourage the RBI to tighten monetary policy.

CPI (consumer price index) inflation was close to 8 percent in April, nearly double the RBI's legally mandated target of 4 percent. Most of this inflation is caused by supply-side bottlenecks, triggered first by the pandemic and subsequently by the Russia-Ukraine war and lockdowns in China. Yet even as supply has been constrained, the RBI has been pursuing an easy monetary policy, aimed at encouraging demand. As a result, inflation has been increasing.

With inflation surging, and the RBI still in "accommodative" mode, the central government has now announced a slew of measures to ease the supply constraints, focusing on those commodities whose prices have increased sharply. It has banned wheat exports, lowered the excise tax to Rs 8 per litre on petrol and Rs 6 per litre on diesel, and reduced the import duty on steel.

That's not all. The government has also imposed an export duty on steel products at the rate of 15 percent and increased the export duty on iron ore from 30 percent to 50 percent. It has imposed a cap on sugar exports. There is a demand to ban cotton exports as well.

It is clear that the government is trying hard to bring down the cost of commodities. But these actions will only have a modest effect on inflation. Part of the reason is that price increases are no longer confined to just a few commodities. Inflation is now broad-based, extending to virtually every good and service in the economy. Further inflationary pressure is building up, as seen from a WPI (wholesale price index) inflation of 15 percent, the highest in more than two decades. As these wholesale price increases are passed through to the retail level, CPI inflation could rise further.

While the government’s bans and market interventions will do little to dent inflation, they are likely to damage growth by undermining exports and investment. Let’s consider these one by one.

India now faces a historic opportunity to use exports as a lever to boost GDP growth. China, the main export engine of the world, has been locking down its factories even as international firms are scouting for new production locations. Meanwhile, Russia is being subjected to ever-tighter economic sanctions. As a result, two large Asian countries are reducing their presence on the international trade landscape, creating an unprecedented scope for India to attract international firms to produce and export from here.

Exploiting this opportunity requires an appropriate policy stance. Perhaps the single most critical element of such a stance would be a stable and consistent trade policy. Whenever the government suddenly bans exports or imposes export duties, it puts firms with export orders in a position where they cannot fulfil their contracts. This is not only embarrassing, it also exposes both exporters and importers to large losses. To avoid this situation, domestic firms will shy away from entering the export business, while foreign firms will be reluctant to place orders with Indian firms. In addition, multinationals will be discouraged from shifting their production to India. After all, why should a firm relocate here, if there is a risk that its exports could be banned, its imports subjected to high duties, and the rules governing its sector changed overnight?

Similarly, sudden and radical policy announcements discourage investment. After two difficult pandemic years, the economy is now reviving, leading firms to consider whether now is the time to start increasing their production capacity. But firms will start to think again when the government alters policy frameworks overnight, even if the change is in a sector far removed from their own. The cost of major investments can only be recouped over a long payback period, and if over this timeframe the government takes an action that renders their investments uneconomic, the firms could end up in serious financial trouble. So better to play safe and avoid major investments.

Finally, the government's actions will affect growth in yet another way. The reduction in excise taxes on petrol and diesel will deprive the centre of revenue at a time when the budget deficit is already far too large. That means the government may need to compensate by cutting spending on infrastructure projects that are vital for the nation’s development.

At this crucial juncture, macroeconomic policy has the delicate task of simultaneously tackling inflation and promoting the recovery. The first task is the job of the RBI. The central bank must take full responsibility for its actions so far, sending a clear signal that henceforth it will focus on bringing inflation down without getting distracted by any other objective. The government on the other hand needs to focus on growth. It needs to reduce market interventions, eliminate prohibitions, and dismantle trade barriers, so that firms are incentivized to export and invest.

If instead, we continue to get the policy “assignments” mixed up, we will end up with objectives that are mixed up. That is, instead of entrenching growth and derailing inflation, we will derail the recovery and entrench inflation. That would not just be a policy mistake. It would be a recipe for a crisis.