A stronger rupee must be part of the Reserve Bank of India’s (RBI) counter-inflationary strategy, say analysts, as a gush of liquidity weakens the impact of other monetary policy tools. Overnight interbank call money rates are as low as 0.5%, despite the RBI’s key benchmark lending rate of 7.75% and last week’s hike in bank reserve requirements to 7.0% from 6.5%.
“Brisk economic growth and strong capital inflows have really complicated monetary policy in the last few months especially,” Anubhuti Sahay, India-based economist at Standard Chartered, told Emerging Markets.
“Liquidity management remains the top priority now, not just to control inflation which has moderated in the near-term, but to manage the exchange rate. However, they will have no option but to allow a stronger currency,” Sahay argued.
The RBI is juggling the competing priorities of an independent monetary policy, an open capital account and a managed exchange rate. It has been intervening to cap the rupee’s gains, buying dollars in a policy that has generated excess cash in the money market.
In an interview with Emerging Markets earlier in the year, RBI governor Yaga Venugopal Reddy accepted that sterilisation of FX inflows via the use of open market operations would ultimately not prevent the appreciation of the rupee.
“High capital inflows impose fiscal costs of sterilizing them, and the decisions regarding the central bank’s ability to sterilize capital inflows and intervene in the foreign exchange market are matters of public policy. In that sense, the manoeuvrability available to the central bank with regard to managing capital flows and the exchange rate is limited.” (For the full interview, please click here).
Karthik Srinivasan, co-head of financial sector ratings at India-based credit rating agency ICRA, agreed that the RBI faced increasing pressures to allow a stronger rupee.
“Despite the political and economic costs of rupee appreciation because of its effect on the competitiveness of exports, the central bank and finance ministry need to acknowledge that liquidity flows cannot be managed without allowing the currency to appreciate,” Srinivasan told Emerging Markets.
However, Srinivasan felt RBI policy was still credible. He cited the fall in inflation from 5.9% at end-March 2007 to 4.4% on July 14, below the central bank’s 5% target.
“Inflation is now within the bank’s comfort zone and liquidity management is maturing so I think the central bank is dealing with the monetary balancing act as best it can,” said Srinivasan.
Sahay acknowledged that the central bank was reasonably effective in managing price expectations, even after the recent severe flooding in the northeast state of Bihar that is likely to drive up food prices. Still, she harboured concerns about the trajectory of inflation, unless rupee appreciation is used as a tool to soften import prices.
“Floods are an annual event in the monsoon season so most analysts have already integrated this factor. Instead I think it is high oil prices that threaten the 5% inflation threshold,” Sahay concluded.
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