139) Inflation: Appreciating rupee not the solution

Though the RBI has been urged to appreciate the rupee to curb the unacceptably high level of inflation, it has done well not to yield to the pressure.

Confronted with an unacceptably high inflation rate of nearly 8 per cent, the ruling UPA Government is understandably worried about its political fallout in the forthcoming State elections and also the Lok Sabha election which is due in the not too distant future.

The ongoing inflation inclusive of oil, cement, steel and other manufactured goods is led by world wide supply shocks and the consequent speculation.

However, inflation at home cannot be strictly treated as imported one since a huge rise in the price of petroleum products has not been fully transmitted to the consumers. Furthermore the food price inflation in India is far less than what prevails overseas.

Nonetheless, the domestic inflation does have a global flavour as domestic price structure is fully aligned with global prices. In response, the RBI has tightened monetary policy and various Ministries have resorted to a series of administrative measures to tame inflation. However, these measures have not fully succeeded.

Will tight monetary policy work when inflation is largely an imported one? Is there any economic rationale to ask the RBI that it must whip up the rupee artificially high so that currency appreciation could counter the pressures of imported inflation?

Monetary medicine
The ongoing inflation is unambiguously not a monetary phenomenon as it is led by a variety of supply shocks operating both at home and abroad. This is not to suggest that there is no demand pull pressure at work. For quite sometime the annual growth rate of M3 money has been ruling well above the target level of 17 per cent.

There was also a huge inflow of capital during 2007-08 and forex reserves swelled by more than $100 billion over the past one year. Along with FDIs and FIIs, ECB (external commercial borrowings) has been significant in the recent period.

Despite reasonable degree of success over sterilisation, the residual effects of capital inflows must have been felt on money supply. When combined with higher growth registered for four successive years, inflation could not be expected to remain quiet and move within the officially declared limit.

The asset price inflation that followed not surprisingly attracted RBI’s attention. The global oil and food crises intervened at this critical juncture, accentuating the inflationary pressures still further.

Central bankers all over the world worry more about inflation than growth; they inevitably employ tight monetary policy to the detriment of the latter and whenever inflation becomes a matter of grave concern they appear willing to compromise on growth to tame inflation.

But they are also aware of the limitations of monetary policy when the global commodity price trends are a major contributor to indigenous inflation. The RBI too is fully conscious of the inadequate nature of traditional monetary policy in negotiating the ongoing inflation.

The RBI’s measures have helped to moderate the housing boom and the volume of mortgage loan has also come down sharply. Monetary tightening was thus very much needed against the backdrop of liquidity build-up through capital inflows. However, one disturbing outcome of such blunt monetary tightening is the marked decline in agricultural credit growth and priority sector lending.

Despite this credit bottleneck, 2007-08 saw a substantial increase in agricultural production. However, on account of problems in procurement and certain other distributional challenges including the critical inability to import at the right time at right prices, India could not insulate itself from the global food inflation. Taming inflation
When central banks all over the world have opted for tight monetary policy, the Fed has been continuously reducing the short-term interest rate to ease the liquidity pressures arising out of the housing and credit crises afflicting the US and other economies for more than a year now.

It should be underlined here that this easy money policy of the US and its spill over on the rest of the world was the instrumental factor for the spread of global inflation which was later compounded by food and oil crises.

As the ongoing inflation is largely triggered by international factors, some argue for rupee appreciation as a solution. In the face of huge foreign exchange reserves accumulated over a period and given its associated costs, it seems sensible to make use of this opportunity to part a fraction of reserves and strengthen the rupee so that the rising import prices and its consequent impact on domestic prices can be moderated.

For the authorities, inflation control via rupee appreciation is more important than its adverse consequences on exports. Any one would concede that in the context of inflation management today, this is the time for the rupee not to depreciate much, but only to appreciate. However, ground level realities suggest the opposite.

First, in the face of boom in commodity prices, more particularly a massive rise in food and oil prices, there has been a commensurate increase in the nominal transaction demand for dollars, leading to depreciation of rupee in the recent times.

Second, the RBI might have thought that it is highly inappropriate to have an appreciated rupee in the present scenario. For instance, most of our importing countries are likely to be plagued by recession. Under the circumstance, any anti-export exchange rate policy will hammer exports with all its attendant consequences on employment.

ExPORT PERFORMANCE
Third, an appreciating rupee could tame domestic inflation without hurting the export performance provided import intensity of our export is sufficiently large and also the exchange rate pass through effect is significant.

Unfortunately, these conditions do not hold good in India where large proportion of export is labour intensive.
Fourth, an appreciated and appreciating exchange rate will be a contradiction in terms when the domestic inflation rate remains at a higher level. This will result in appreciation of real exchange rate which will hurt export growth. Thus, external depreciation of rupee taking place now is a natural consequence of internal depreciation; this will prevent the real exchange rate from appreciating and thus keep it in line with the fundamentals.

This might also give relief to those segments of the economy which have suffered in the recent past and survived with non exchange rate support of the Government.

To conclude, regardless of the standard criticism levelled against the RBI that it has not mastered the art of managing its monetary policy, it can be stated that massive inflows of foreign exchange and rising inflation have been negotiated well by the central bank.

It has not yielded to the pressure of making the rupee to appreciate. However, the time has come to ease the monetary policy and usher in a soft interest rate regime which can fit into the depreciating rupee now and both will help the real economy. There are reasons to believe that the rupee is over shooting now only to rebound at a later stage. Therefore there is no need to panic about the current depreciation of rupee.

D. Sambandhan, M. Ramachandran

(D. Sambandhan is Professor and Head at the Department of Politics and International Studies, Pondicherry University. M. Ramachandran is Professor at the Department of Economics, Pondicherry University.)