Monetary Policy in India: Ila Patnaik Ajay Shah

Monetary Policy in India
Ila Patnaik Ajay Shah
DEA, July 2007
Ila Patnaik, Ajay Shah ()
DEA, July 2007
1 / 48
Part I What is monetary policy and how does it work?
DEA, July 2007
2 / 48
What is monetary policy?
Monetary policy is the management of money supply and interest rates by central banks to inuence prices and employment. Monetary policy works through expansion or contraction of investment and consumption expenditure.
DEA, July 2007
3 / 48
The uses of monetary policy
Monetary policy cannot change long-term trend growth. There is no long-term tradeoff between growth and ination. (High ination can only hurt growth). What monetary policy at its best can deliver is low and stable ination, and thereby reduce the volatility of the business cycle. When inationary 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.
DEA, July 2007
4 / 48
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 ination 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 nancial prices. There is no contradiction between nancial sector development and an effective monetary policy! Key words: focus, independence, transparency, predictability, accountability.
Ila Patnaik, Ajay Shah () Monetary Policy in India DEA, July 2007 5 / 48
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. Indias long-term reform agenda: drop CRR and SLR, which would increase the money multiplier.
DEA, July 2007
6 / 48
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
DEA, July 2007
7 / 48
Part II Impossible trinity
DEA, July 2007
8 / 48
Monetary policy in an open economy
Impossible trinity: Open capital account Pegged currency regime Independent monetary policy
DEA, July 2007
9 / 48
Example Let us say you have ination and so want a contractionary monetary policy. You raise interest rates. Since the capital account is open, capital ows in from abroad in response to the higher interest rates. This puts a pressure on the rupee to appreciate.
DEA, July 2007
10 / 48
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 difculties: 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.
DEA, July 2007
11 / 48
Example If the US hikes the Fed rate, and India stays still, capital will ow 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.
DEA, July 2007
12 / 48
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.
DEA, July 2007
13 / 48
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 scal costs Sterilisation means selling bonds rates go up sucks in more capital ows.
India has served up ideal textbook examples of: the difculties of the impossible trinity, of the feasibility of sterilised intervention in the short run, of the breakdown of sterilised intervention after a short while.
Ila Patnaik, Ajay Shah () Monetary Policy in India DEA, July 2007 14 / 48
Part III The story of Indian monetary policy
DEA, July 2007
15 / 48
Conceptual framework
1 2 3
What was happening in the exchange rate regime? How was the currency regime being implemented? What were the consequences of the implementation of the exchange rate regime for monetary policy?
DEA, July 2007
16 / 48
Four phases of the INR exchange rate regime
Squared weekly returns
10
15
20
25
1995
2000
2005
DEA, July 2007
17 / 48
Four phases of the INR exchange rate regime
INR/USD rate
35
40
45
1995
2000
2005
DEA, July 2007
18 / 48
INR/USD volatility in the 4 periods
Period I II III IV
Annualised INR/USD vol 1.71 7.02 2.02 4.57
For a comparison: Euro/USD annualised vol is 9.6%.
DEA, July 2007
19 / 48
The evolution of the INR exchange rate regime
Period 1: April 1993 to February 1995 Period where trading in the INR rst 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 exibility in Indias experience. Period 3: August 1998 to March 2004 Tight pegging, with low volatility and some appreciation. Period 4: March 2004 - Greater currency exibility.
DEA, July 2007
20 / 48
DEA, July 2007
20 / 48
DEA, July 2007
20 / 48
DEA, July 2007
20 / 48
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.
DEA, July 2007
21 / 48
Period 1
1 2 3 4 5 6 7
Began as a surge in capital inows. RBI bought USD to prevent appreciation beyond Rs.31.37. There was no bond market to speak of. NFA and M0 went up. M3 growth accelerated. Ination rate rose to 16 percent. Monetary tightening through CRR and interest rate hikes started when faced with high ination. This was after a year of almost no sterlisation.
DEA, July 2007
22 / 48
Period 2: loss of control
Period of the Asian crisis High rupee vol January 1998: interest rate defence of rupee.
DEA, July 2007
23 / 48
Period 3: Successful sterilised intervention
1 2 3 4 5 6
By now the bond market was much better developed. The bond market was actively used for OMO. CRR phaseout program stayed on course. M0 and M3 growth were contained Ination remained below 10 percent. But the real rate dropped to negative numbers, thus setting the stage for trouble after Period 3. Period 3 broke down when RBI ran out of government bonds for OMO.
DEA, July 2007
24 / 48
Part IV Current challenges to monetary policy (Period IV)
DEA, July 2007
25 / 48
Challenge of open economy
Year 1999-00 2006-07
Gross ows Trillion rupees Percent to GDP 9.16 51.28 41.18 110.01
Measured in rupees: gross ows across the current and capital accounts grew by 4.5 times in seven years.
DEA, July 2007
26 / 48
Difculties
1
RBI ran out of stocks of government bonds in May 2004, at the end of Period 3. M0 is smaller than NFA(!). Monetary Stabilisation Bonds were started but explicit scal cost; no longer the hidden costs of pegging. 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. In 2006-07 reserve money growth rose to 23 per cent. Rising ination a worry
2 3
5 6
DEA, July 2007
27 / 48
Massive reserves buildup

Phase IV
FX Reserves
Billion USD
120
140
160
180
2005
2006
2007
DEA, July 2007 28 / 48
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.
DEA, July 2007
29 / 48
Ineffectual sterilisation - OMO + MSS

Phase IV
40000
OMO+MSS RBI fx purchases
Rs. crore
20000
20000
2005
2006
2007
DEA, July 2007 30 / 48
Compare against sterilisation of Period III

Phase III
15000
OMO+MSS RBI fx purchases
Rs. crore
15000
5000
5000
1999
2000
2001
2002
2003
2004
DEA, July 2007 31 / 48
Movement of NFA and M0

Phase IV
NFA M0 NDA
Levels (Rs. crore)
2e+05
2e+05
6e+05
2005
2006
2007
DEA, July 2007 32 / 48
Compare against the picture in Period III

5e+05
Phase III
NFA M0 NDA
Levels (Rs. crore)
1e+05
1e+05
3e+05
1999
2000
2001
2002
2003
2004
DEA, July 2007 33 / 48
Acceleration in M0 and M3 growth

24
Phase IV
Growth in M0 Growth in M3
Percentage change (YOY)
10
12
14
16
18
20
22
2005
2006
2007
DEA, July 2007 34 / 48
Reversal of reforms on CRR phaseout

6.0
Phase IV
CRR
Percent 4.5 5.0
5.5
2005
2006
2007
DEA, July 2007 35 / 48
Compare against the fuller picture on CRR phaseout

Full Period
CRR
Percent
10
12
14
1995
2000
2005
DEA, July 2007 36 / 48
Improvement of money multiplier got stalled

5.0
Phase IV
M3/M0
4.6
4.7
4.8
4.9
2005
2006
2007
DEA, July 2007 37 / 48
Inationary pressures
Phase IV
Inflation
Percent
2005
2006
2007
DEA, July 2007 38 / 48
Monetary policy has tried to tighten?

Phase IV
7.5
CRR 91day rate
Percent
4.5
5.0
5.5
6.0
6.5
7.0
2005
2006
2007
DEA, July 2007 39 / 48
What is the monetary policy?

24
Phase IV
7.5 2006
22
M0 growth 91day rate (right axis)
20
Percent
18
16
14
2005
2007
DEA, July 2007 40 / 48
4.5
10
5.0
12
5.5
6.0
6.5
7.0

22
Phase IV
7.5 2006
M3 growth 91day rate (right axis)
20
Percent
18
16
12
2005
2007
DEA, July 2007 41 / 48
4.5
5.0
14
5.5
6.0
6.5
7.0
Monetary policy has been behind the curve

Phase IV
8
91day rate WPI inflation
Percent
2005
2006
2007
DEA, July 2007 42 / 48
Real rates remain too low to reduce ination

Phase IV
Real interest rate
Percent
2005
2006
2007
DEA, July 2007 43 / 48
In a mature market economy, the central bank unambiguously pins down the short rate. The nancial 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.
DEA, July 2007
44 / 48
Part V Summary
DEA, July 2007
45 / 48
Key messages
Monetary policy is supposed to be about pinning down the short rate so as to achieve an ination 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. Indias monetary regime is largely Indias exchange rate regime: Period 1 MP was dominated by Rs.31.37 (unsterilised) Period 2 Currency exibility + interest rate defence Period 3 Sterilised intervention Period 4 Confusion. The biggest question today: What is the monetary policy?
DEA, July 2007
46 / 48
Further reading
Indias 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
DEA, July 2007
47 / 48
Thank you.
DEA, July 2007
48 / 48

Monetary Policy in India: Ila Patnaik Ajay Shah

Uploaded by

Copyright:

Available Formats

You might also like

Monetary Policy in India: Ila Patnaik Ajay Shah

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Monetary Policy in India: Ila Patnaik Ajay Shah

Uploaded by

Copyright:

Available Formats

Monetary Policy in India

Ila Patnaik Ajay Shah

DEA, July 2007

Ila Patnaik, Ajay Shah ()