Monitory Policy

Monetary Policy in India
Ila Patnaik Ajay Shah
DEA, July 2007
Ila Patnaik, Ajay Shah () Monetary Policy in India DEA, July 2007 1 / 48
Part I
What is monetary policy and how does it work?
What is monetary policy?
Monetary policy is the management of money supply and interest

rates by central banks to influence prices and employment.
Monetary policy works through expansion or contraction of
investment and consumption expenditure.
The uses of monetary policy
Monetary policy cannot change long-term trend growth.

There is no long-term tradeoff between growth and inflation. (High
inflation can only hurt growth).
What monetary policy – at its best – can deliver is low and stable
inflation, and thereby reduce the volatility of the business cycle.
When inflationary pressures build up:
raise the short-term interest rate (the policy rate)
which raises real rates across the economy
which squeezes consumption and investment.
The pain is not concentrated at a few points, as is the case with
government interventions in commodity markets.
How central banks of mature market economies work
Election cycle in interest rates
Hence, political independence for the narrow task of monetary
policy
The central bank sets the short rate
The market either explicitly or implicitly knows the inflation target
of the central bank.
The short rate is unambiguously set by the central bank and is
known to everyone.
The “monetary transmission” : the market process through which
changes to the short rate lead to changes in all other interest rates
and financial prices.
There is no contradiction between financial sector development
and an effective monetary policy!
Key words: focus, independence, transparency, predictability,
accountability.
Money creation
Reserve money is created when the central bank either lends to

the government, or buys foreign exchange thus adding to
reserves.
Reserve money (M0 ) induces broad money (M3 ) through the
‘money multiplier’.
India’s long-term reform agenda: drop CRR and SLR, which
would increase the money multiplier.
Instruments of monetary policy in India
Net loans to central government (i.e. open market operations)

Net purchase of foreign currency assets
Change in cash reserve ratio
Changes in repo rate and reverse repo rate
Bank rate
Part II
Impossible trinity
Monetary policy in an open economy
Impossible trinity:
Open capital account
Pegged currency regime
Independent monetary policy
Example
Let us say you have inflation and so want a contractionary
monetary policy.
You raise interest rates.
Since the capital account is open, capital flows in from abroad in
response to the higher interest rates.
This puts a pressure on the rupee to appreciate.
But the exchange rate is pegged
Example
The Central Bank buys up the dollars coming in to prevent rupee
appreciation.
This leads to an expansion in net foreign exchange assets of the
Central Bank and and thus of money supply.
Classic symptom of impossible trinity difficulties: raising interest
rates but money supply growth is surging.
An expansion in money supply will lower interest rates.
You cannot raise rates, and keep the exchange rate pegged at the
same time.
Example
If the US hikes the Fed rate, and India stays still, capital will flow
out and the currency will depreciate.
If the RBI wants to prevent depreciation of the currency, it will have
to sell dollars or raise rates. Both these are contractionary.
Currency pegging forces RBI to also raise rates.
Thus having a peg means following US monetary policy.
A country with an open capital account cannot hope to have an

independent monetary policy if it runs a pegged exchange rate.
Pegging the exchange rate induces a loss of monetary policy
autonomy.
Sterilised intervention
Can the impossible trinity be dodged?

The central bank could try to impact money supply through open
market operations. This is “sterilising” the impact of the forex
intervention.
This works for a short while (only). There is no long-term escape.
Constraints to sterilisation:
Run out of bonds
Mounting fiscal costs
Sterilisation means selling bonds → rates go up → sucks in more
capital flows.
India has served up ideal textbook examples of:
the difficulties of the impossible trinity,
of the feasibility of sterilised intervention in the short run,
of the breakdown of sterilised intervention after a short while.
Part III
The story of Indian monetary policy
Conceptual framework
1 What was happening in the exchange rate regime?

2 How was the currency regime being implemented?
3 What were the consequences of the implementation of the
exchange rate regime for monetary policy?
Four phases of the INR exchange rate regime
25
Squared weekly returns
20
15
10
5
0
1995 2000 2005
Four phases of the INR exchange rate regime
45
INR/USD rate
40
35
1995 2000 2005
INR/USD volatility in the 4 periods
Period Annualised INR/USD vol

I 1.71
II 7.02
III 2.02
IV 4.57
For a comparison: Euro/USD annualised vol is 9.6%.
The evolution of the INR exchange rate regime
Period 1: April 1993 to February 1995 Period where trading in the INR first
began. For most of this period the exchange rate was Rs.31.37
per dollar.
Period 2: February 1995 to August 1998 The period of the Asian crisis, there
was the highest-ever currency flexibility in India’s experience.
Period 3: August 1998 to March 2004 Tight pegging, with low volatility and
some appreciation.
Period 4: March 2004 - Greater currency flexibility.
per dollar.
some appreciation.
per dollar.
some appreciation.
per dollar.
some appreciation.
Monetary policy in the four phases
Period 1: April 1993 to February 1995 Unsterilised intervention.

Period 2: February 1995 to August 1998 Asian crisis; least pegging.
Period 3: August 1998 to March 2004 Sterilised intervention.
Period 4: March 2004 - Confusion.
Period 1
1 Began as a surge in capital inflows.

2 RBI bought USD to prevent appreciation beyond Rs.31.37.
3 There was no bond market to speak of.
4 NFA and M0 went up.
5 M3 growth accelerated.
6 Inflation rate rose to 16 percent.
7 Monetary tightening through CRR and interest rate hikes started
when faced with high inflation. This was after a year of almost no
sterlisation.
Period 2: “loss of control”
Period of the Asian crisis

High rupee vol
January 1998: interest rate defence of rupee.
Period 3: Successful sterilised intervention
1 By now the bond market was much better developed.

2 The bond market was actively used for OMO.
3 CRR phaseout program stayed on course.
4 M0 and M3 growth were contained
5 Inflation remained below 10 percent.
6 But the real rate dropped to negative numbers, thus setting the
stage for trouble after Period 3.
7 Period 3 broke down when RBI ran out of government bonds for
OMO.
Part IV
Current challenges to monetary policy (Period IV)
Challenge of open economy
Year Gross flows

Trillion rupees Percent to GDP
1999-00 9.16 51.28
2006-07 41.18 110.01
Measured in rupees: gross flows across the current and capital

accounts grew by 4.5 times in seven years.
Difficulties
1 RBI ran out of stocks of government bonds in May 2004, at the

end of Period 3.
2 M0 is smaller than NFA(!).
3 Monetary Stabilisation Bonds were started – but explicit fiscal
cost; no longer the hidden costs of pegging.
4 Forex intervention continued - endeavour to get exchange rate
back under control.
Greater globalisation requires bigger market manipulation - e.g.
$12 billion in February 2007 alone.
Only partly sterilised.
5 In 2006-07 reserve money growth rose to 23 per cent.
6 Rising inflation a worry
Massive reserves buildup
Phase IV
FX Reserves
180
160
Billion USD
140
120
2005 2006 2007

Was sterilisation effective?
Effective sterilisation means that the graph of RBI purchases of

foreign currency should be the mirror image of the graph of RBI
sale of bonds through OMO + MSS.
This is broadly the case in Period III but not in Period IV.
Ineffectual sterilisation - OMO + MSS
Phase IV
OMO+MSS
RBI fx purchases
40000
20000
Rs. crore
0
−20000
2005 2006 2007

Compare against sterilisation of Period III
15000 Phase III
OMO+MSS
RBI fx purchases
5000
Rs. crore
0
−5000
−15000
1999 2000 2001 2002 2003 2004

Movement of NFA and M0
Phase IV
NFA
M0
NDA
6e+05
Levels (Rs. crore)
2e+05
−2e+05
2005 2006 2007

Compare against the picture in Period III
5e+05 Phase III
NFA
M0
NDA
3e+05
Levels (Rs. crore)
1e+05
−1e+05
1999 2000 2001 2002 2003 2004

Acceleration in M0 and M3 growth
24 Phase IV
Growth in M0
Growth in M3
22
Percentage change (YOY)
20
18
16
14
12
10
2005 2006 2007

Reversal of reforms on CRR phaseout
6.0 Phase IV
CRR
5.5
Percent
5.0
4.5
2005 2006 2007

Compare against the fuller picture on CRR phaseout
Full Period
CRR
14
12
Percent
10
8
6
1995 2000 2005

Improvement of money multiplier got stalled
5.0 Phase IV
M3/M0
4.9
4.8
4.7
4.6
2005 2006 2007

Inflationary pressures
Phase IV
Inflation
8
7
Percent
6
5
4
2005 2006 2007

Monetary policy has tried to tighten?
Phase IV
CRR
7.5
91−day rate
7.0
6.5
Percent
6.0
5.5
5.0
4.5
2005 2006 2007

What is the monetary policy?
24 Phase IV
M0 growth
7.5
91−day rate (right axis)
22
7.0
20
6.5
18
Percent
6.0
16
5.5
14
5.0
12
4.5
10
2005 2006 2007

22 Phase IV
M3 growth
7.5
91−day rate (right axis)
20
7.0
6.5
18
Percent
6.0
16
5.5
5.0
14
4.5
12
2005 2006 2007

Monetary policy has been behind the curve
Phase IV
91−day rate
WPI inflation
8
7
Percent
6
5
4
2005 2006 2007

Real rates remain too low to reduce inflation
Phase IV
Real interest rate
2
1
0
Percent
−1
−2
−3
2005 2006 2007

In a mature market economy, the central bank unambiguously

pins down the short rate.
The financial markets are told the ‘monetary policy rule’ so they
have expectations about future values of the short rate.
Using this, the market traces out the full yield curve.
RBI has two short rates, not one: 6% and 7.75%.
At 7.75% the transactions are roughly zero.
At 6% the transactions are capped at Rs.3000 crore.
The central bank has stopped performing its core function, that of
pinning down the short rate.
Part V
Summary
Key messages
Monetary policy is supposed to be about pinning down the short

rate so as to achieve an inflation target, and thus stabilise the
macroeconomy.
Pegged exchange rate + de facto convertibility “uses up” the lever
of monetary policy.
There is a loss of autonomy in the conduct of monetary policy.
India’s monetary regime is largely India’s exchange rate regime:
Period 1 MP was dominated by Rs.31.37 (unsterilised)
Period 2 Currency flexibility + interest rate defence
Period 3 Sterilised intervention
Period 4 Confusion.
The biggest question today: What is the monetary policy?
Further reading
India’s experience with a pegged exchange rate by Ila Patnaik, in India

Policy Forum 2004, Brookings Institution Press and NCAER, 2005,
edited by Suman Bery, Barry Bosworth and Arvind Panagariya.
http://openlib.org/home/ila/PDFDOCS/Patnaik2004_implementation.pdf
Thank you.

Monitory Policy

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Monitory Policy

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Monetary Policy in India

Ila Patnaik Ajay Shah

DEA, July 2007

What is monetary policy and how does it work?

Monetary policy is the management of money supply and interest

Monetary policy cannot change long-term trend growth.

Reserve money is created when the central bank either lends to

Net loans to central government (i.e. open market operations)

A country with an open capital account cannot hope to have an

Can the impossible trinity be dodged?

The story of Indian monetary policy

1 What was happening in the exchange rate regime?

1995 2000 2005

1995 2000 2005

Period Annualised INR/USD vol

For a comparison: Euro/USD annualised vol is 9.6%.

Period 1: April 1993 to February 1995 Unsterilised intervention.

1 Began as a surge in capital inflows.

Period of the Asian crisis

1 By now the bond market was much better developed.

Current challenges to monetary policy (Period IV)

Year Gross flows

Measured in rupees: gross flows across the current and capital

1 RBI ran out of stocks of government bonds in May 2004, at the

2005 2006 2007

Effective sterilisation means that the graph of RBI purchases of

2005 2006 2007

1999 2000 2001 2002 2003 2004

2005 2006 2007

1999 2000 2001 2002 2003 2004

2005 2006 2007

2005 2006 2007

1995 2000 2005

2005 2006 2007

2005 2006 2007

2005 2006 2007

2005 2006 2007

2005 2006 2007

2005 2006 2007

2005 2006 2007

In a mature market economy, the central bank unambiguously

Monetary policy is supposed to be about pinning down the short

India’s experience with a pegged exchange rate by Ila Patnaik, in India

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