The problem of plenty

D Subbarao, Governor, Reserve Bank of India, has been confronted with diverse challenges for long now. And the RBI's annual policy statement acknowledges the tightrope walk for Subbarao. As the domestic balance of risks shifts from growth slowdown to inflation, the policy stance must recognise and respond to this transition, says the RBI. "This time, calibrating the policy was a big dilemma for us. It was more difficult than before as we had to maintain a finer balance," says Subbarao.

The bigger dilemma is the paradox of higher capital flows because of better growth prospects in India—and the challenge it poses. Appreciation of the rupee is one of those challenges. Academically, when inflation shoots up in an economy which has a current account deficit, its currency should depreciate. But the exact opposite has been happening with the rupee.

SUBBARAO'S TRILEMMA Inflation PROBLEM: Has exceeded RBI's target of 8.5 per cent, with prices of manufactured goods too rising. ACTION: CRR hiked in January, Repo and reserve Repo rates in March and CRR, Repo and reverse Repo rates in April. Exchange Rate PROBLEM: Net capital inflows at $42 billion during April-December 2009 were six times the $7 billion in the same period last year. The rupee appreciated by over 15 per cent during 2009-10 up to February (compared to a 10.4% depreciation in the previous year). ACTION: RBI says it's monitoring exchange rate volatility and its potentially harmful impact on the real economy. Interest Rate PROBLEM: Rate hikes would hurt recovery, private credit offtake and government borrowing programme. ACTION: Smaller, 25 basis point hike in policy rates to shield the recovery. The stated motive is not to hamper the recovery process.

Says Subbarao: "We do not look at the exchange rate as an instrument for managing inflation." In his January policy review, Subbarao had highlighted capital inflows as the next big threat after inflation. "We do not want too much in excess of current account deficit and that is what we are hoping for and that is what we will calibrate our policy towards."

Here's why the RBI is worried. In 2009-10, capital inflows have surged to over $90 billion. And capital inflows to India during 2010-11 are expected to be stronger. While the push factors for a surge in capital inflows include excess global liquidity accompanied by low interest rates leading to search for higher yield, the pull factors include the buoyant growth prospects and favourable interest rate differential.

And that gives jitters to Indian exporters, particularly the small and medium enterprises (SMEs). "Currency volatility in either direction is bad news for SMEs," says Anil Bhardwaj, Secretary General, Federation of Indian Micro and Small & Medium Enterprises (FISME).

So, would RBI step in to do active capital account management? "We feel that a greater RBI intervention (USD purchase) is on the cards," says Deepali Bhargava, Chief Economist, ING Vysya Bank. Subbarao rules out any such move. "At eight per cent GDP growth, we would need finance. We are only worried about capital flows in excess of our absorptive capacity," he says. But, clearly, the central bank could spring to action soon. "When inflows were in excess, we had modulated NRI deposits and ECB flows," he adds. So, something similar cannot be ruled out.

Back to Subbarao's dilemma, he admits that RBI would have moved more slowly towards normalisation if it were not for an inflationary situation. "The smaller rate hikes are just apt at a time when the purpose is not to constrain the nascent credit growth recovery," says Bhargava of ING Vysya. The RBI Governor, however, is keeping his options open: "I will not rule out mid-cycle action, because we do not know how the situation will evolve." He has quite a task ahead of him.