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Wednesday, February 19, 2014

‘Why sacrifice domestic growth for exchange rate stability?’ 02-19




‘Why sacrifice domestic growth for exchange rate stability?’



IIMB expert flays rate hike in monetary policy, quotes First Law of Holes to RBI - Stop digging, when you find yourself in a hole.
The Reserve Bank of India unexpectedly raised its policy interest rate on Tuesday by 25 basis points (bps) but said that if consumer price inflation eases as projected, it does not foresee further near-term tightening. The RBI raised its policy repo rate by 25 bps to 8%.
Dr Charan Singh, RBI Chair Professor, IIMB, calls the move "unwarranted" and describes it as the "last straw on the camel's back". He thinks, in emerging countries without any unemployment dole, there is no long run, for poor can be dead in the short run itself.
The rate hike, announced by the RBI, on Tuesday (January 28), was not expected by most market players given that inflation was in check. Is the rate hike disappointing?
The repo rate has been raised from 7.75 per cent to 8 percent. There is certainly a surprise element. I wish the hike had not taken place because prices had stabilized. To me, this affects the credibility of the Reserve Bank because in their last policy statement they had said if the prices stabilize, then they would not hike the rate of interest.
Also, an additional factor has been brought into the monetary policy statement, which is the exchange rate concern. To me, high interest rate is not going to help in view of the avalanche that will follow the tapering, if that happens as a general trend with all the emerging countries. A 25 basis points hike is not going to stop the outflow when the time comes. Rather, it will only further stifle growth and industrial production in the domestic economy.
There is another fundamental flaw to the policy: Why should we hold the rupee artificially at a level where it does not belong? Everybody in the market knows the CPI differential between India and the US has been massive historically; the rupee has to find its equilibrium level. Why should we sacrifice domestic growth for exchange rate stability?
In India, we do not have employment figures. The rising unemployment, because of slowing economic growth, is not measured. If that was being measured, it would have shown critical levels already. And this additional rate hike is going to slow production, slow growth and increase unemployment.
I am not convinced that the rate hike was warranted. Neither was I convinced when the last rate hike was done.
Would you day the financial crisis and the Great Recession have changed the way that consumers, bankers, business managers and regulators think and behave? No one seems to assume basic economic stability any more.
Yes, behavior has changed. The Great Recession has taken place after nearly three generations and few individuals have memories of the Great Depression. The global economy is slowing and this is impacting in a contagion manner, sequentially. But in advanced countries, there is forward guidance that runs more than two years ahead. In other words, they announce what they will do for the next two years; they have it conditional either on unemployment figures or on inflation figures and they follow it in letter and spirit.
In India, we do our credibility no favors because we make statements but we do not follow them up. Less than six weeks ago, the statement was that in case inflation comes down, the RBI would consider not changing the repo rate. What has happened now? Inflation has come down but the rate has been raised! Forward guidance is missing in India.
Monetary policy (the influencing of interest rates, credit conditions and the money supply) is powerful, but it is not some potion that, taken in the right doses, can magically calm the business cycle, is it?
Monetary policy is not a magic potion, yes but it can certainly help in stabilizing a critically charged environment. This happens across the world, especially during elections, when fiscal policy is expansionary. It is very important that the monetary policy plays a stabilizing role then. However, the stabilizing role has to be played carefully. If it is overdone, it can impact growth.
In India, the fiscal policy is expansionary and the macroeconomic and monetary development review accompanying the (RBI) Governor's statement clearly says that the deficit has shot up. The situation is grim. Tax collections are low. In a country like India, where dole is not provided to the unemployed and growth is impacted, people are left feeling desperate. This can lead to frustration and enhanced crime. This can also lead to unemployed masses joining political rallies and leading to upturn in political fates.
Subsidies are rising because of the Food Security Act and because of rising petroleum subsidies. When deficits are rising and the monetary policy does not give cognizance to growth undercurrents in the economy, the situation will obviously turn grave.
I understand that the monetary policy is being framed in very uncertain times. But I would have thought that in these uncertain times instead of adding the last straw on the camel's back, the interest rate should have been left untouched.
Any other thoughts?
Yes.
It is very surprising that the monetary policy is unilaterally implementing the Urjit Panel Report. Are other countries targeting inflation in a crisis? Should we target inflation in a critical situation when growth is slowing? These are the issues which need to be discussed.
Secondly, what is real rate of interest? If nominal rates are rising when inflation is stabilizing, then obviously the real rate of interest is rising. Does it not deter investment?  It is important to consider as to how is the market perceiving the intention of raising the interest rates. These issues must also be discussed widely before implementing the Urjit Report.
Thirdly, is this philosophy of raising the interest rate like making a straw man face an upcoming storm? When the tapering starts and when the global economy is in an uncertain phase and when exchange rates of emerging countries start losing their value, would this interest rate not turn into a straw man in a storm? In the meantime, we would have impacted our domestic economy adversely. We have to understand that short run and long run are terms for the rich and for economists. A poor man, on losing a job, is finished, emotionally and socially. For a poor man, there is no long run, for he may be dead in the short run itself. Hence, sacrificing growth even in the short run, when social security does not exist is not fair policy in an emerging country but certainly is in advanced countries which support their unemployed with substantial dole.
I would like to quote from the First Law of Holes, stated by the then British Chancellor of the Exchequer Denis Healey. "If you find yourself in a hole, stop digging!" It is time to stop digging in India.