The RBI's recent initiatives aimed at stabilising the rupee confirm its recently acquired image of being autonomous, but the central bank is neither independent of international finance nor is its intervention always effective.
AN impressionistic reading of the financial press suggests that India's central bank has suffered a loss in popularity. 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. The rupee's depreciation itself was not too substantial, especially given the perception that currencies of India's competitors have, since the South-East Asian crisis, fallen far more vis-a-vis the dollar. What appears to have bothered the RBI is the pace at which that depreciation occurred. Sensing that the unusually sharp depreciation was driven by speculation, the RBI responded in two ways.
It first put a halt to and marginally reversed its drive to reduce interest rates by easing liquidity and cutting the Bank Rate. On July 21, the Bank Rate, which had in six instalments been brought down from 11 per cent in January 1998 to 7 per cent in A pril 2000, was hiked by one percentage point to 8 per cent. The Cash Reserve Ratio (CRR) too was raised by half a percentage point to 8.5 per cent. The RBI had decided to stabilise the rupee by squeezing credit and rendering it more expensive. Underlying those moves 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 do llar 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 al lowed exporters to hold a portion of their exchange earnings in foreign currency accounts. Since exporters were eligible to avail themselves of credit against such holdings to meet current expenses, holding on to dollar revenues in the form of long-term deposits was not much of 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 dec ided to reduce the ceiling on such deposits by 50 per cent, with an August 23 deadline for conversion. This 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 resumed its downward slide, nearing the Rs.46-to-the-dollar mark.
The initiatives aimed at stabilising the rupee seem to confirm the RBI's recently acquired image of being an independent and autonomous central bank that can go against the grain and discipline the private sector in the pursuit of its objectives. They ha ve also created the impression that Governor Bimal Jalan is India's own version of an Alan Greenspan (Chairman of the Federal Reserve Board of the United States), willing to exercise the authority that the newly acquired status of the central bank vests in him. 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. 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 lower ing of interest rates and a depreciation of the rupee so as to stimulate industrial growth and exports respectively, are uncomfortable with the tough-acting central bank chief.
Interestingly, it was this section of the bureaucracy inspired by the International Monetary Fund (IMF) and the World Bank that had made the case for an independent and autonomous central bank. In theory, central bank autonomy was seen as 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. Until 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 finance compulsorily.
This obviously reduced the central bank's control over money supply. Fiscal decisions that increased the 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 prevailin g monetarism believed that money supply trends were responsible for inflationary conditions, the central bank's pursuit of what was seen as its primary objective, namely maintaining price stability, was seen as having been eroded. Restoring a role for mo netary policy was predicated on curbing the ability of the government to finance its deficits through the issue of ad hoc Treasury Bills.
It was not only because of their faith in monetary policy that the reformers were in favour of central bank autonomy. They also believed that once the government's access to cheap credit from the RBI was curtailed, government borrowing would be limited f or two reasons: excessive borrowing from the open market will push up interest rates, providing a signal to the government of the impact of its behaviour on the cost and availability of credit; excessive borrowing will also result in sharp increases in t he interest burden on the government's budget, and act as a corrective against such borrowing. Since the reformers were persuaded by the view that the size of the fiscal deficit constituted India's number one economic problem, they backed central bank au tonomy as a solution to that problem.
In the event, as part of the financial reform effort, the issue of ad hoc Treasury Bills was initially capped and subsequently done away with and replaced with a scheme of ways and means advances. However, as the evidence shows, this has not helped ensur e any substantial reduction in the fiscal deficit. In fact, there have been three years after the launch of reform during which the fiscal deficit to gross domestic product (GDP) ratio has come close to the levels seen during the crisis of 1990-91. First in 1993-94, when government expenditure was increased to combat the immediate post-adjustment recession. And second, during 1998-99 and 1999-2000, when the implementation of the Pay Commission's recommendations pushed up the salary bill of the governmen t.
What is disconcerting is that this increase in the deficit has not provided any major expansionary stimulus to the system. This is because associated with a higher 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 higher fiscal deficit to GDP ratio does not imply an e quivalently higher expenditure to GDP ratio. The net impact has been that despite relatively high and rising fiscal deficits 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 to reduce inflation. This was because, even while a fall in credit to the government limited the rise i n 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. In the event, the fo reign 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 av ailable 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 statutory 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 investm ents in other savings instruments such as National Savings Certificates and provident funds and in 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 wh ich 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 o n 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 CRR and releasing funds to be provided as credit by the bank s. 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 governm ent in its effort to bring down the rate of interest on small savings instruments and provident funds, so as to encourage household investments in market instruments as well as to reduce the interest burden of the government, which is the principal borro wer 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 j oint 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. The reason, of course, is a lack of any expansionary stimulus. While government expenditure net of interest payments is down relative to GDP, exports, which were to provide the new engin e 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 has required not just a curb on the fiscal deficit, but also the abolishment of the practice of financ ing it with low interest ad hoc Treasury Bills. Thus the curb on 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 s timulus to industrial growth has been substantially eroded. What is appalling is that this has occurred at a time when the combination of burgeoning food stocks that are proving to be an embarrassment, large foreign exchange reserves, low inflation and h igh 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.
BUT is the RBI really autonomous? 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. How ever, 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 a nd 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 t he 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. In order to combat this, the central bank regularly has had to demand and purchase dollars, resulting in a substantial rise in the foreign currency assets of the central bank. Such a rise, by contributing to money supply increases, limits the autonomy of the central bank on the monetary policy front.
That is not all. The volatility in foreign capital flows tends to limit further the manoeuvrability of the central bank even further. Consider for example the year 1999-2000, which was one in which foreign investment inflows into the country, having fall en from $5.4 billion in 1997-98 to $2.4 billion in 1998-99, rose once again to touch $5.2 billion. 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 s tabilise its value vis-a-vis the rupee. Net purchases of foreign currency from the market by the RBI 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 c urrency 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. 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.
But things changed suddenly in the current financial year. 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 (Foreign Institutional Investor) 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 on a part of their past investments and diverting funds to other markets. According to market sources, the strengthening of interest rates in the U.S. and the recovery of markets elsewhere in Asia have enco uraged 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, 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 t hat it is headed downwards sets off speculation on 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 mone tary policy thrust aimed at stimulating growth. This makes nonsense of the view that reform has rendered the central bank more autonomous and monetary policy more effective. The accumulation of foreign currency assets in the hands of the RBI, which exerc ises a crucial influence on money supply, is clearly determined by the whimsical behaviour of the foreign financial investor. And despite such accumulation aimed at regulating the rupee's movement, the RBI has found itself in a situation where it has ha d 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. Yet, the evidence of success on that front is still ambiguous. Clearly, the central bank is neithe r independent of international finance, nor is its intervention always effective.