Friday, April 11, 2008

'Ideal' Inflation & Exchange Rates for India

Shyam Ponappa / New Delhi July 05, 2007

What India needs and how to get there.

My last article addressed how strategic use of low interest rates could help achieve better living standards ( This one explores what the “right” inflation and exchange rates might be, and suggests next steps.


What is the desirable inflation rate? We must think beyond fixed mindsets to address circumstances as they are, and determine what we can do. Otherwise, we have the ludicrous situation of self-inflicted damage that threatens to hobble growth yet again. How ironical that delegations scour the globe soliciting investment; and yet, when larger capital flows occur, they induce a state of near-hysteria against inflation. The RBI raises rates, to a chorus of approving groans. Thus, perversely, positive developments become the very impediments to progress. This must change for India to grow at a sustained 9-10 per cent or more.

Do we want those capital inflows, or not? Do we want to grow around 10 per cent a year, or not?

An inescapable consequence of growth is that there will be increasing foreign investment. If we avoid moving quickly to full convertibility, we escape some of the volatility associated with it. In my opinion, this market is simply not ready for high volatility (translation: we will not be able to stomach the carnage, so the detriments will overwhelm the benefits). It will be when a preponderance of attributes moves it out of the “emerging markets” category. Meanwhile, incentives can influence flows towards FDI rather than secondary markets or asset bubbles, reducing inflationary pressures. But some of the supply pressure for inflation and overvaluation needs to be channelled into profitable, liquid offshore investments. On inflation, Dr Rangarajan’s view* is that the “threshold” of 5-6 per cent he suggested years ago was for that time, and the ideal rate for India “…depends on what the rest of the world is doing. If the rest of the world is gearing towards… 2-2.5 per cent, we cannot have an inflation rate well above that rate. Therefore, about 3 to 4 per cent is an acceptable inflation rate for the medium term. For now we should be gearing towards 4 per cent...” Paraphrasing, 2-2.5 per cent is desirable but unrealistic, hence a near-term 4 per cent (the WPI is nearly there), with a lower medium-term goal.

Apart from interest/growth-related reasons, inflation hurts the poorest the most. With high prevailing growth, we need the lowest inflation achievable (1-2 per cent?), facilitating low interest and strong growth across a broad front.

Supply Pressures & Export-Friendly Exchange Rates

Some appreciation of the rupee is inevitable with a strengthening economy, while undervaluation benefits many exporters. Net benefits to the economy, however, vary with a number of factors, e.g., energy prices, as a stronger rupee is beneficial for energy imports and import-dependent exports, while a weaker or undervalued rupee benefits those using local products and services. That said, there are compelling reasons for assisting growth engines (IT/KPO, etc.), despite all the counter-arguments. The same holds for manufacturing, while this sector builds quality and volume. System responses, therefore, need careful evaluation.

What Rate?

Should India try to manage the Nominal Exchange Rate, the Real Effective Exchange Rate, or something else? CRISIL has an index described in a recent article by Radhika Anand and Subir Gokarn called, rather infelicitously, the “Parameter of Competitiveness” (PARC).** This compares the rupee with the export-weighted and inflation-adjusted currencies of India’s competitors for exports. It shows the rupee has been appreciating against competitor currencies since the end of 2005. The RBI has every reason to use this, or a similar measure, as a criterion for evaluating exchange intervention.

Strategy & Execution

Recognising that we cannot say “no” to inflows and must say “yes” to growth, what should we do differently?

Set growth objectives—10%+: Goal-oriented planning begins with clear objectives. This means accepting one or a few non-contradictory, overriding objective/s. Then, coordinating responses to achieve it/them. Confused yearnings, fears or wish-lists are not a good starting point.

Analyse dispassionately: For instance, stop viewing trade deficits with lingering fears of scarcity: if a significant deficit arises from increases in imports for growth, this is quite different from, say, a preponderance of oil imports. Growth-oriented imports mean that we are importing capital, exactly as we must.

Coordinate fiscal & monetary policy: The conventional wisdom is that the benefits of an independent Central Bank accrue at no cost to the economy. A report in the European Journal of Political Economy, however, finds that when monetary and fiscal authorities pursue their goals independently, conflicts arise that render both sets of goals less achievable.*** This happens: “because unrestrained competition between independent policy makers creates conflicts in which one policy has to be used (in part) to neutralise the other.” The upshot is that goals are subverted, and cannot be achieved efficiently. The more populist a government’s actions, the more the Central Bank becomes inflation-averse.

Strategy and coordination can help achieve the next three items.

Keep inflation and interest rates low: This is detailed in my previous article ( and in the next paragraphs.

Invest foreign exchange reserves abroad: The RBI knows it can invest reserves abroad in remunerative ways. Yet, our culture of crucifying those who achieve breakthroughs ensures that first-movers will suffer if there is a misstep. Therefore, this decision must be a multi-partisan and empowered-Group-of-Ministers’ initiative.Those who think China began creatively investing its reserves with Blackstone in 2007 should be aware it was investing—whether from reserves or from another account—in strategic enterprises such as phosphoric acid in America, or real estate in Thailand—nearly 20 years ago. Time to wake up and act! $5 billion in an offshore infrastructure investment vehicle is one thing. $50 billion in liquid funds with returns of possibly over 20 per cent and much more is what we must do immediately. Then, $100 billion.

Structural solutions for chronic shortages: Formulate long-term, systematic, strategic initiatives for energy, pulses, food grains, sugar… instead of repetitively dealing with periodic crises. Instances are: strategic alliances/investments for oil and gas (as begun), appropriate support prices combined with distribution systems that work better for food grains, and a long-term pulses strategy.


It is time to think and act strategically and systematically, in concert, to build a virtuous cycle on low interest, inflation, and exchange rates.

* “There is no growth-inflation tradeoff”, interview with BS:

** “Rupee impact is large, but not the only one”:

*** “An independent Central Bank faced with elected governments,” Demertzis, Hallett & Viegi:

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