Reserve bank of india: Why RBI’s Urjit Patel should follow former Fed chairman Ben Bernanke’s ‘Operation Twist’–Economic Times–11.08.2017

Dr Y V Reddy as Reserve Bank of India governor had many run-ins with the government. One such prominent event was when he articulated the usefulness of Tobin Tax to temper overseas fund flows. In an unprecedented move, the then Finance Minister, P Chidambaram, forced the governor to recall his speech and clarify that no such proposal was on the horizon. That was January 12, 2005. The flow of US dollars fuelled asset prices across the board – from real estate, to stocks, to commodities, to precious metals. That lulled corporates into believing easy money is forever. When the tide turned those with dollar liabilities were whipsawed.

Within a few years of tackling the problem of plenty with the Greenback during Reddy’s tenure, the country quickly moved to scarcity under Governor Duvvuri Subbarao in 2013. Subbarao and his successor, Raghuram Rajan, worked overtime to arrest the collapse of the rupee and come up with yet another special scheme to bring in US dollars.

Come 2017, life at the Reserve Bank of India (RBI) appears to have come a full circle. Yet again, it is a problem of plenty. The foreign exchange reserves are at a record high of $393 billion. The RBI has purchased about $50 billion from the market this year — both from the spot as well as the forward markets — to slow currency appreciation. But that’s not helping.

Despite the Federal Reserve’s U-turn to normalisation, the US dollar tide doesn’t appear to be turning anytime soon. Contrary to textbook economics, which says that a reduction in interest rate will lead to a fall in the value of a currency, the Indian rupee rose to a two-year high when the Monetary Policy Committee cut the benchmark interest rate last week.

Something is amiss. India’s current high real interest rate of about 4% along with its prudent policies of inflation targeting, and a tight fiscal policy, are drawing yield hungry global investors.

Overseas investors net bought Indian stocks and bonds worth a record Rs 1.75 lakh crore in 2017. The fact that global investors have almost exhausted their limits of Rs 4.32 lakh crore in both sovereign and corporate debt indicate how lucrative it is to own Indian fixed-income instruments.

The trust of global investors may be a matter of pride for an emerging economy like India, but it may be sowing the seeds of financial instability that poses challenges to Governor Urjit Patel, and make importers complacent, while creating anxious moments for exporters.

“An independent inflation targeting monetary policy does have implications for the FX market and capital flows,’’ says Ananth Narayan, head of markets for ASEAN and South Asia at Standard Chartered Bank. “Among other reasons, perceived high rupee returns may be one of the reasons for the current rupee outperformance. Foreign portfolio flows are coming in, and looking at the perceived high interest-rate differentials, more exporters may be hedging than importers.’’

When the currency surges 6.2% and capital flow is liberal, being a central banker with a mandate to control inflation with interest rate alone, is like getting thrown into the boxing ring with hands tied. Economists, in general, call it the impossible trinity – an autonomous monetary policy, free capital movement, and exchange rate management.

The current record low inflation of 1.54% is abnormal for an emerging country like India. RBI’s inflation mandate is forcing it to keep interest rate high with uncertainties like global financial risks when the impact of slow tightening by the Fed begins to pinch and commodity prices and crude turn.

The RBI can lower short-term rates, but keep longer term rates high to face uncertainties. While the limits on bond holdings may stop the flow into fixed-income instruments as we know, trust the market to find a way to circumvent it. The RBI may have to get bring down short-term interest rates, but keep the long tenor high to match its fear of uncertainties — from revival of price pressures, to global financial market turmoil.

Dr Reddy may not be the ideal guide here for Patel, but he can borrow from former Fed chairman Ben Bernanke’s book. To help Main Street benefit from his loose monetary policy, Bernanke launched his ‘Operation Twist’. He lowered yield on long-tenor securities by buying them with the sale proceeds of short-term notes. Patel can conduct an ‘Operation Twist’ in reverse.

via reserve bank of india: Why RBI’s Urjit Patel should follow former Fed chairman Ben Bernanke’s ‘Operation Twist’

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