Monetary Policy : Post - Reform

In recent weeks, economic attention has been focused on the rupee, which has registered a sharp fall in its value relative to the dollar. On one occasion the rupee's value in intra-day trading even fell below the psychological benchmark of Rs. 46 to the dollar. In the event, the RBI, which till recently had been lauded for it efficient management of India's balance of payments, appears to have suffered a loss in popularity. This is not so much because of the depreciation of the rupee itself, but because of the manner in which the RBI responded to that depreciation. Industrialists and exporters are sore about the manner in which the Reserve Bank of India has dealt with the recent slide in the rupee's value.
 
To start with, in July, the RBI responded to the beginnings of the rupee's slide by reversing its agenda of easing money supply and reducing interest rates by periodically reducing both the Cash Reserve Ratio (CRR) applicable to the banking system, and the Bank Rate, or the rate at which the central bank provides credit to the banking system. The most recent set of such reductions was announced on April 1, 2000. Four months later, the Bank Rate which had been brought down in six instalments from 11 per cent in January 1998 to 7 per cent as recently as April 2000 was, on 21 July, hiked by one percentage point to 8 per cent. The CRR too was raised by half a percentage point to 8.5 per cent. The RBI had decided to stabilise the rupee by choking off credit and rendering it more expensive.
 
Underlying that move was the perception that easy access to liquidity at low interest rates was encouraging agents eligible to trade in foreign exchange markets to book profits through arbitrage. So long as the expected slide in the rupee vis-a-vis the dollar exceeded the cost of acquiring and using rupee debt to purchase dollars, it paid to borrow rupee funds and invest them in dollars for speculative purposes. In the belief that such speculation played a role in the rupee's sudden depreciation, the RBI chose to mop up some of the liquidity in the system and render credit more expensive.
 
When this action failed to halt the rupee's slide, the RBI decided to force exporters to convert into rupees a substantial part of their dollar holdings under the Exchange Earners' Foreign Currency (EEFC) Account scheme introduced in 1992. That scheme allowed exporters to hold a portion of their exchange earnings in foreign currency accounts. Since exporters were eligible to avail credit against such holdings to meet current expenses, holding on to dollar revenues in the form of long term deposits was not much a problem. What is more, to the extent that the rupee depreciated, increasing the rupee value of these dollar holdings, the exporters garnered a higher rupee return. Thus, the scheme, which was meant to facilitate easy access to foreign exchange by exporters, became a means to maximise returns by speculating on the likely depreciation of the rupee. Having discovered that at the time of the rupee's slide exporters were holding dollar deposits amounting to $2 billion, the RBI decided to reduce the ceiling up to which such deposits could be held by 50 per cent, with an August 23 deadline for conversion, which triggered a conversion rush that stabilised and even pushed up the value of the rupee. However, after the deadline, by which date $850 million had reportedly been converted, the rupee once resumed its downward slide, nearing the Rs. 46-to-the-dollar mark.
 
These manoeuvres of the central bank were surprising to many because the rupee's depreciation itself was not too substantial, especially given the perception that currencies of India's competitors have, since the Southeast Asian crisis, fallen far more vis-a-vis the dollar. The initiatives have also not been received well. The decision to hike interest rates, coming in the midst of signs that industrial growth is once again slowing has been criticised by industry associations and individual captains of industry. And exporters are sore about the curtailment of the EEFC account benefit available to them. Rumour has it that sections of the bureaucracy which are keen to dispel the impression that the growth rates of output and exports during the years of reform have been low and volatile, and are therefore in favour of a further lowering of interest rates and a depreciation of the rupee so as to stimulate industrial growth and exports respectively, are uncomfortable with the increasingly independent central bank chief.
 
But is the RBI really autonomous? And has monetary policy acquired a role which it did not have before the reform? In theory central bank autonomy is seen as the end result of the process of rendering central bank operations relatively independent of the fiscal decisions of the government, so that the RBI could adopt an effective monetary policy. Till the early 1990s a major way in which the deficit in the budget of the central government was financed was through the issue of ad hoc Treasury Bills, which provided the government access to funds at a relatively low interest rate. Once the volume of open market borrowing by the government was decided upon, the remaining gap in the budget was automatically monetised through the issue of ad hocs, as they were called, which the RBI was expected to compulsorily finance.
 
This obviously reduced the central bank's control over money supply. Fiscal decisions that increased the central bank's credit to the government, also increased the high powered money base in the system, leading to an increase in money supply. Since the prevailing monetarism believed that money supply trends were responsible for inflationary conditions, the central bank's pursuit of what was seen as its primary objective, viz. price stability, was seen as having been eroded. Restoring a role for monetary policy was predicated on curbing the ability of the government to finance its deficits through issue of ad hoc Treasury Bills. In pursuit of that goal, the government entered into an agreement with the central bank to put an annual ceiling on the issue of Treasury Bills, to reduce that ceiling over time, and finally to do away with the practice of monetising the deficit through the issue of ad hocs. That agreement has been successfully implemented, leading to a sharp fall in the monetised deficit and ostensibly increasing the autonomy of the RBI and enhancing the tole of monetary policy.
 
The whittling down of the monetised deficit does seem to have increased the confidence of India's central bank, judging by the tone of the Reserve Bank of India's Annual Report for 1999-2000. If the Report is to be believed, monetary policy during 1999-2000 was driven by the need to ensure that "all legitimate requirements for credit were met while guarding against the any emergence of inflationary pressures." With industrial growth having picked up from less than 4 per cent in 1998-99 to more than 8 per cent in 1999-2000 (Chart 1), private demand for credit must have been on the rise. Yet broad money growth stood at just "13.9 per cent, which was substantially below the long-run average of a little over 17.0 per cent."

This lower growth had occurred despite the fact that with the average rate of inflation at a decadal low (Chart 2), there was no immediate threat of an inflationary upsurge. What is more, demand supply imbalances, which could be worsened by an easy liquidity situation, do not seem to have been responsible even for the low rate of price increase recorded. As Chart 3 shows, primary commodities, whose prices are driven by such imbalances contributed little to the oserved inflation rate. Much of the increase was due to administered price increases (Chart 4), which pushed up prices in the Fuel and Manufactured Products groups.

In rhetoric, the context of low inflation is seen to have provided the RBI with the opportunity of focusing its attention on growth. Some stimulus for growth seemed necessitated by the fact that one of the major stimuli for growth prior to reform, namely the expansionary influence of deficit-financed government spending, had been substantially dampened as a result of reform. This occurred in two ways. First, through a curtailment of the fiscal deficit. As Chart 6 shows, the average fiscal deficit-to-GDP ratio, which stood at 7.2 per cent during the 1980s and was brought down marginally to 6.7 per cent during the first half of the 1990s has come down further to 5.6 per cent during the second half of the 1990s. Second, associated with a lower fiscal deficit has been a lower tax-GDP ratio, resulting from the fact that while indirect tax collections, especially customs duty collections, have fallen as a result of reform-driven tariff reductions, direct tax collections have not risen enough to neutralise this fall. As a result, a given level of the fiscal deficit-to-GDP ratio does not imply a similar expansionary stimulus prior to and after reform, because post-reform figures are associated with lower revenues and expenditures relative to GDP. The net impact has been that during the 1990s, industrial growth has been indifferent in most years.

This fact of indifferent industrial performance did influence the conduct of the now autonomous central bank. In the initial years of liberalisation, the battle against inflation was the RBI's principal concern. But this battle was soon won without much effort. After the initial period of monetary stringency that accompanied IMF-style adjustment, the RBI itself was hard put to curb money supply growth which its monetarist faith suggested was the key to reducing inflation. In fact, as Chart 5 shows, broad money grew by over 19 per cent a year during the first half of the 1990s. This was partly because, even while a fall in credit to the government limited the rise in the central bank's assets, the inflow of dollars into India's liberalised financial markets was forcing the RBI to demand and buy dollars in order to prevent an appreciation of the increasingly market-determined value of the rupee. As Chart 8 shows capital inflows rose sharply to more than $.8.5 billion in 1993-94 and 1994-95. This rise was clearly on account of large inflows of portfolio investments (Table 1), in response to which the RBI had to purchase dollars to prevent an appreciation of the rupee. In the event, the foreign currency assets of the central bank tended to rise, increasing the high-powered money base and therefore the level of money supply. But this did not defeat the RBI's drive to keep inflation under control, since the liberalisation of imports in the context of a decline in inflation worldwide and the reduction in the expansionary stimulus provided by government spending was in itself contributing to a dampening of inflation.

With inflation proving to be less of a problem, the RBI shifted the focus of its policy to growth. Since financial reform required a further curtailment of an expansionary stimulus provided by government spending, the only instrument that seemed to be available to spur industrial growth was a reduction in interest rates. However, nominal interest rates in the system had reached extremely high levels in the wake of reform. And this high rate of interest persisted even as access to liquidity in the system was eased as a result of the rising foreign currency reserves. There was one obvious reason why interest rates were sticky downwards. This was the high floor that risk free government bonds provided to the structure of interest rates. With the government deprived of access to cheap funds from the mint as a result of the curb on the issue of ad hoc Treasury Bills, it had to finance its persisting fiscal deficits by borrowing from the open market at market-determined rates. Once the banks had met their statutorily required investment levels in government securities, government bonds could be placed in the market only if the interest rates on such investment offered a good enough spread to the banks relative to the deposit rates paid by them. Given the relative high interest rates that depositors could obtain from other investments in other savings instruments like National Savings Certificates and Provident Funds and in more risky holdings of equity, deposit rates had to be kept relatively high to attract funds into the banking system. This meant that the interest rates offered on government bonds had to remain high as well. Since these were virtually risk-free investments, carrying as they do a sovereign guarantee, these relatively high interest rates on government bonds defined the floor to the structure of interest rates which at one time stretched to maximum levels of well above 20 per cent.
 
Faced with this situation and given its resolve to bring down interest rates, the RBI moved in four directions. First, it relaxed controls on interest rates on deposits, giving banks the flexibility to reduce them on longer term deposits and raise them on short-term deposits, so as to reduce their average interest costs without curbing deposit growth. Second, it substantially enhanced liquidity in the system by systematically bringing down the cash reserve ratio and releasing funds to be provided as credit by the banks. Third, it reduced by as much as 4 percentage points the Bank Rate, which is the rate at which banks can obtain finance from the central bank and therefore serves as an indicative rate for the market for funds. And finally, it colluded with the government in its effort to bring down the rate of interest on small savings instruments and provident funds, so as to encourage households investments in market instruments as well as to reduce the interest burden of the government which is the principal borrower of funds invested through those channels.
 
This combination of initiatives has indeed been successful in bringing down interest rates, making the now autonomous central bank appear doubly successful. It could claim success in dampening inflation and it could be satisfied with the results of its joint effort with the government to bring down interest rates. However, the objective behind the drive to reduce interest rates, namely, that of stimulating industrial growth remains unrealised. After a temporary reprieve during 1999-2000, the industrial sector is back to the sluggish performance recorded since 1997-98. And even during 1999-2000, the recovery in growth does not seem to have stimulated investment. It is this factor which possibly explains the slower growth of commercial credit and money supply during that year. The reason industrial sluggishness is, of course, the lack of any expansionary stimulus. While government expenditure net of interest payments is down relative to GDP, exports which were to provide the new engine of growth in the wake of reform have remained at disappointing levels.
 
The point to note is that the lack of any fiscal stimulus is in large part the result of the effort to give the central bank greater independence. This, as discussed earlier, has required not just a curb on the fiscal deficit, but also the abolishment of the practice of financing it with low interest ad hoc Treasury Bills. Thus the curb on the deficit, during a period of shrinking revenues, has been accompanied by a rise in the interest burden on the government's budget. Not surprisingly, the role of government expenditure as a stimulus to industrial growth has been substantially eroded. What is appalling is that this has occurred at a time when the combination of burgeoning foodstocks that are proving to be an embarrassment, large foreign exchange reserves, low inflation and high unutilised capacity in industry, makes an obvious case for a major fiscal stimulus aimed at raising output and employment without stoking inflation. But that opportunity has been lost by the adherence to an orthodox monetary and fiscal policy regime that emphasises central bank autonomy.
 
What is more, even autonomy has proved to be limited, because of the role of volatile capital flows into the economy. As mentioned earlier, one area in which the RBI has been forced to be active in the wake of reform is the liberalised foreign exchange market. The supply and demand for dollars in that market does influence the level of the exchange rate. However, in the wake of financial reform the supply of dollars is no more determined by the inflow of foreign exchange due to current account transactions such as exports and remittances. Rather, inflows on the capital account in the form of private debt and foreign direct and portfolio investment, are a major determinant of supply at the margin.
 
Such inflows have increased significantly in the wake of the financial reform of the 1990s. But such increased inflows have not been matched by the demand for dollars from a not-too-buoyant economy. In the event, an excess supply of foreign exchange in the market has tended to push up the value of the rupee at a time when India has consistently recorded a deficit on its current account. To combat this, the central bank has had to regularly demand and purchase dollars, resulting in a substantial rise in the foreign currency assets of the central bank. Such a rise as we have mentioned earlier, by contributing to money supply increases, limits the autonomy of the central bank on the monetary policy front.
 
But that is not all. The volatility in foreign capital flows tends to further limit the manoeuvrability of the central bank even further. Consider for example the year 1999-2000, which was one in which foreign capital inflows into the country, having fallen from $12 billion in 1996-97 to $9.8 bilion in 1997-98 to $8.6 billion in 1998-999, rose once again to touch $10.2 billion (Chart 8). This should have strengthened the rupee. It did not because the RBI, as in the past, stepped in to buy dollars, increase the demand for that currency and stabilise its value vis-à-vis the rupee. Net purchases of foreign currency from the market by the Reserve Bank of India amounted to $3.25 billion between end-March 1999 and end-March 2000. These purchases resulted, among other things, in an increase in the foreign currency assets of the central bank from $29.5 billion at the end of 1998-99 to $35.1 billion at the end of 1999-2000. Most of these purchases occurred between end-September 1999 and end-February 2000 (Chart 7). The large demand for dollars that this intervention by the RBI in foreign exchange markets resulted in, helped keep the rupee relatively stable during financial year 1999-2000. However, that stability concealed a new source of vulnerability. As Chart 9 indicates, the share of stable capital flows (or flows other than portfolio investments, short-term debt and NRI deposits), which had risen to account for almost 90 per cent of all flows by 1998/99, fell to 46 per cent of the total in 1999-2000.

This vulnerability partly explains why things have changed suddenly this financial year. Thus over the first three months of 2000-01, for which we have information, while exports have staged a recovery, imports have grown even faster, resulting in an increase in the trade deficit relative to the corresponding period of the previous year. But what has been an even more depressing influence on the rupee are signs that portfolio investments have turned negative, and rapidly so. Net FII investments, which in April stood at $617 million, fell to $111 million in May, and turned negative as of June, with outflows estimated at $218 million in June and around $300 million in July.
 
Clearly, institutional investors are cashing in a part of their past investments and diverting funds to other markets. According to market sources, the strengthening of interest rates in the US and the recovery of markets elsewhere in Asia have encouraged a shift of FII focus away from India. The point is that this consequence of developments elsewhere has had a dampening effect on the value of the rupee, which is now perceived as being "overvalued".
 
This should not have mattered much, especially given the fact that the rupee has appreciated vis-a-vis a range of currencies other than the dollar. However, given the liberalised nature of financial markets, any perception that a currency is overvalued and that it is headed downwards sets off speculation in the currency. And once such speculative activity is triggered, speculative expectations tend to realise themselves leading to a downward spiral in the currency's value. The RBI's "knee-jerk" reaction to the recent slide in the rupee's value suggests that it believed that some authorised dealers and exporters were acquiring and holding dollars for speculative purposes, so that an ostensibly warranted and welcome depreciation of the rupee could soon turn into collapse, with a host of adverse implications. It is only that perception that can explain the heavy-handed response of the central bank in the form of a squeeze in liquidity, hike in interest rates and a cap on dollar holdings in EEFC accounts.
 
Whatever the sequence of events that led up to that perception, it is clear that the whimsical behaviour of foreign investors and speculative activity in India's liberalised foreign exchange markets has forced the RBI to divert from its well planned monetary policy thrust aimed at stimulating growth. This substantially erodes the validity of the view that reform has rendered the central bank more autonomous and monetary policy more effective. Despite the accumulation of foreign currency assets in the hands of the RBI, it has found itself in a situation where it has had to make changes to the Bank Rate, the CRR and the ease of access to foreign exchange, in order to counter speculation in the market for foreign exchange. And yet, the evidence of success of the effort at stabilising the rupee is still ambiguous.