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First term at Monetary Towers - Outside View by S.S. TARAPORE

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First term at Monetary Towers
Sep 6, 2013

Raghuram Rajan has been anointed as the new High Priest at the Temple of Money. The outside world is curious regarding the secrets of the Temple. As Governor Raghuram Rajan entered the sanctum sanctorum in the corner office on the 18th floor of Monetary Towers, he would have gathered that the well-guarded secret is that there are no secrets - only a large dish of problems. While Raghuram Rajan needs no advice, it may be useful to discuss some booby traps.

It is considered axiomatic that our problem is lack of investment and all that needs to be done is to step up investment. There is little or no interest in the trade cycle. We could do with some advice from Prof. Gita Gopinath, a specialist in trade cycles in the Emerging Market Economies.

EasING Monetary Policy

We need to appreciate the crucial upper turning point in the Hayekian over-investment theory, where there is an excess of investment over savings, which is filled through forced savings via printed money. The nerves of the central bank get tested as inflation gathers momentum. As the brakes are applied, the economy goes into a downturn. The art of good monetary management is to undertake monetary tightening well before the upper turning point is reached, which would enable the economy to creep along the ceiling of growth as long as possible. In India, monetary policy action gets delayed till well after the upper turning point of the cycle which aggravates the downturn.

At present, growth has declined, retail inflation is raging and there is a possibility of an exodus of foreign capital and severe pressure on the exchange rate. While the situation calls for a Paul Volcker 1980s type of unswerving monetary tightening, government, industry, financial analysts and academic economists argue for a substantial monetary easing. In such a situation, the RBI would find it difficult to undertake any sharp monetary tightening; but it needs to at least resist monetary easing.

The RBI should prominently articulate the need for inflation control, while making the right genuflections on growth and employment. Any significant easing of monetary policy would only aggravate the already large balance of payments' current account deficit (CAD).

Exchange rate management

At present, the RBI provides accommodation at 7.25 per cent under the repo and 10.25 per cent under the Marginal Standing Facility (MSF), which does not make for good monetary management. One approach would be to undertake a calibrated reduction in the MSF rate along with an increase in the repo rate. There should, however, be no relaxation of reserve requirements at this stage.

There is a need for a de novo examination of the underlying rationale of exchange rate policy. During the 1990s, the RBI explicitly used the trade weighted Real Effective Exchange Rate (REER) as the pole star for exchange rate management. With the rapid increase in services, the REER was de-emphasised.

For the past decade, the RBI's policy has been to contain 'volatility'. In the recent period, the RBI would have had to intervene massively with sales when the rupee fell precipitously and undertaken large purchases when the rupee appreciated sharply; the RBI seems to have done neither.

The RBI needs to have some perception of what it considers as the 'appropriate exchange rate'. If it swears by controlling 'volatility', it should strictly undertake spot sales simultaneously with forward purchases or inter-temporal forward-to-forward transactions.

The RBI would do well to use the secular long-term inflation rate differential (based on the Consumer Price Index) between India and the major industrial countries to determine the 'appropriate' exchange rate. The macho aspirations are for a strong rupee, claiming that Indian productivity is higher than the rest of the world and, therefore, it is concluded that at the present time, the rupee is undervalued. We should, perhaps, be more humble!

The authorities need to recognise that an unsustainable CAD warrants a nominal depreciation of the rupee. There is an erroneous view that a depreciation is inflationary and an appreciation is disinflationary. There is a need to understand the concept of 'absorption' which would turn the popular perception upside down.

Gold and CAD

While a large part of the CAD in 2012-13 is attributed to gold imports, it is necessary to appreciate that restricting or banning gold imports does not reduce the CAD. All that would happen is an increase in illicit gold imports and a reduction in invisible inflows as also over-invoicing of imports and under-invoicing of exports.

As recommended by the RBI's K. U. B. Rao Report, a Bullion Corporation should be set up quickly for monetising domestic gold. A gold-for-gold bond could be offered at, say, 7 per cent and the gold on-lent to users of gold. Since it would take, say, six months to set up the Bullion Corporation, it would be best to issue a gold bond immediately and then transfer the liabilities and assets to the Bullion Corporation. Mobilising domestic gold would cut the CAD.

The High Priest's Philosophy

There are a host of other issues which will need the new RBI Governor's immediate attention. The RBI watchers would avidly wait to hear the new High Priest's philosophy of central banking. Raghuram Rajan has aptly put it that he does not have a magic wand. But his mere appointment has generated a strong vote of confidence.

Raghuram Rajan should remind himself that any significant monetary easing would worsen the current account deficit.

Please Note: This article was first published in The Hindu Business Line on September 06, 2013.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.


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