The Government of India and the Reserve Bank of India signed a Memorandum of Understanding on March 25, 2004 detailing the rationale and operational modalities of a Market Stabilisation Scheme, effective from April 2004 for absorbing liquidity from the system.
Under this arrangement the government would issue treasury bills and/or dated securities with a ceiling on the amount. The bills and securities would be matched by an equivalent cash balance held by the government with the RBI. For 2004-05, the ceiling is fixed at Rs 60,000 crore (Rs 600 billion).
Why MSS? With the large-scale inflow of foreign exchange assets, the expected appreciation of rupee and resulting adverse effect on exports prompts the RBI to intervene in the foreign exchange market and keep the rupee stable.
However, this may cause money growth to exceed the target rate of growth required by the anticipated growth of the real economy, and stoke inflation.
Therefore, excess money supplied through the purchase of foreign exchange is sucked back by selling domestic assets available with the RBI.
Thus, the RBI keeps replacing its domestic assets with foreign assets at a rate that corresponds with the forex inflow, as if the exchange rate is one of the targets of monetary policy.
As a result of this operation, the RBI has almost completely drained its domestic assets holding and foreign exchange assets have become almost the only source of reserve money supply; therefore, the independence of monetary policy is under threat.
The threat is real because the growth rate of forex assets with the banking sector (due to net inflows) is almost double the required growth in reserve money. Since the RBI wants to target both inflation as well as the exchange rate, it must have sufficient domestic assets.
There are, however, only limited options for acquiring domestic assets without increasing base money supply. Among the possible means to obtain domestic assets, one could be converting the government's external debt with domestic assets with the RBI.
Another option is the MSS. Both are costly. However, domestic interest rates being much higher than international rates, MSS could be the costlier option.
What is the cost of MSS? Consider the February stock of base money as Rs 4,05,200 crore (Rs 4,052 billion) and net forex assets as Rs 5,20,400 crore (Rs 5,204 billion), the required rate of growth of base money as 10 per cent and the expected rate of growth of forex assets as 25 per cent.
Assuming the rest of the policy environment is constant, the approximate amount to be sterilised to keep the exchange rate stable will be Rs 89,600 crore (Rs 896 billion).
Thus, the provision of Rs 60,000 crore (Rs 600 billion) for the next year under MSS seems to be a good guess and the whole amount is likely to be consumed at say 4.5 per cent yield on 91-day treasury bills. Thus, the cost would be at least Rs 2,700 crore (Rs 27 billion).
There is no doubt that the RBI has carefully chosen the MSS route. Such schemes have been successfully used in other countries, although there is a perpetual cost, which limits its potential to be a sustainable solution.
The composition and the trends of foreign exchange inflow during the past few years indicate that the flow will be sustained. So next year the RBI may require another similar amount, and so on.
In that case the interest liability of the government will get compounded annually, on a perpetual basis. Is this then a solution to the problem? In other words, does MSS really address the problem of undesired inflows?
It is now amply clear for an economy that is globalising, several aspects of capital controls become myths. The inevitable will happen and the financial system must gear up for this. The system's efficiency must be reflected in reducing the gap between domestic and international interest rates, adjusted for relative inflation.
The current differential is too large. The yields on short and medium term government securities in India are almost four times those prevailing in the United States, while the bank rate of the RBI is almost six times that of the federal funds rate.
The problem seems to lie in the multiplicity of monetary policy targets. While the RBI may be prudent in checking acute volatility in currency markets, the explicit target variable must be identified clearly, against which the effectiveness of policy stances could be monitored.
Although the RBI could choose the real effective exchange rate or inflation alone or nominal income as its policy target, inflation targeting has of late found more favour among central bankers than other variables. This can help competitiveness as well, besides providing macroeconomic stability.
A low inflation, low interest rate regime is easier to manage and will provide more credibility. A lower interest rate and high forex assets would also be advantageous while opening up the capital account, besides discouraging unnecessary inflows.
In this context one should appreciate that inflation in India is not purely a monetary phenomenon, at least in the short and medium run; the role of money is small. Therefore, increases in money supply are likely to push interest rates to lower levels without much increase in prices, particularly if the fuel price inflation is small.
Therefore, the RBI should avail any opportunity provided by low inflation to push down interest rates by allowing more domestic money through open market purchases of forex assets.
The Y-o-Y appreciation of the rupee against the US dollar started around January 2003, reaching 5.7 per cent in February 2004, the apparent causes being the swelling of reserves and the improved current account.
However, the 5-country real exchange rate index appreciated on a Y-o-Y basis only in June 2003 and reached 3.9 per cent in August. The real appreciation was arrested at around 1.13 per cent in February 2004.
Thus, there is some concern among exporters due to possible loss of competitiveness. However, this concern may be misplaced when viewed in totality. The appreciation of the rupee has led to some softening of domestic prices through its effect on oil prices. It is for this reason that moderate currency appreciation should not be feared much.
In a related development the announcements made by the finance minister on January 8, 2004 about the 5 per cent cut in custom duties with the maximum cut on capital goods imports and abolition of the special auxiliary duty, would also have partly neutralised the effect of foreign currency inflows on exchange rate movements.
Another important announcement was about allowing Indian companies to invest abroad up to the tune of their net worth. This can be seen as an attempt to ease some of the pressure of foreign currency purchases and thereby complement the monetary policy stance.
Thus, it would appear that solutions based on liberalisation of the external sector, including the capital account and financial sectors, bringing interest rates closer to international levels and defining inflation as the key monetary policy target, are likely to be more sustainable than short-term arrangements.
The author is at NCAER. These are his personal views