Bharat Jhunjhunwala

Accretion of reserves benefits the foreign consumer, large industries and exporters, but it hurts investment. It seems, therefore, that the result of the economic policy is to not export wealth, to reduce the consumption of the Indian consumer, to hurt small industries and throttle domestic growth.

THE Reserve Bank of India has increased the short-term interest rates to reduce liquidity in the economy and proactively dispel fears of inflation.

However, reduced commercial lending will have an adverse impact on economic growth. Must economic growth be sacrificed to control inflation or is there an alternative?

The current inflation is the result of problems in supply and demand. Domestic prices are experiencing supply-side pressures due to the recent surge in international oil prices.

Simultaneously, heavy FII inflows are causing demand-side pressure.

There is little the RBI can do about oil prices. However, demand-side pressures can be managed by incorporating certain policy changes or options.

The RBI could use the dollars brought in by FIIs in two ways: to buy US Treasury Bills and accumulate forex reserves; or sell them to the Indian forex market. What is the impact of these two policies on inflation and the value of the Indian rupee?

Accretion of forex reserves leads to domestic inflation. The RBI trades its printed currency with the FIIs in exchange for their dollars, leading to a rise in domestic money supply, which exerts a demand-side pressure on inflation.

On the other hand, the sale of dollars absorbs the same amount of liquidity from the domestic money market as the dollars are bought by importers.

The demand side pressure on inflation, therefore, is not due to FII inflows per se, but due to the RBI's practice of using them for accretion of forex reserves.

The impact of the two policy options on the value of the rupee is also different. Accretion of reserves ensures that the dollars brought in through the FIIs do not directly impact the economy. There is no impact on the dollar-rupee exchange rate. On the other hand, the sale of dollars by the RBI would lead to an increase in the supply of dollars in the domestic forex market, lowering value of the dollar while leading to a corresponding increase in the value of the rupee.

The choice before the RBI, then, is to use the FIIs inflows for accumulation of forex reserves. This will lead to demand-side inflationary pressures but will have no impact on the exchange rate.

Alternatively, the RBI could sell the dollars in the forex market. While this will contain inflation, the value of the rupee will rise.

But since it has adopted the policy of accretion, the RBI has increased the short-term interest rates to neutralise demand-side pressures and contain domestic prices.

Let us examine the impact of the two policies on various stakeholders in this backdrop.

On consumers: The benefit of accretion of reserves and a lower rupee goes to the foreign consumer. The dollars deposited with the US Federal Reserve Board for purchase of US Treasury Bills provide the American consumer with money for buying Indian goods, at a cheaper rate because the value of the rupee is held down.

On the other hand, the Indian consumer is deprived of economic growth which is throttled by reducing credit in the economy. He has to pay higher interest rates as well.

But there are some benefits as well. The increased rupee value lowers the prices of imported goods. Lower domestic inflation keeps the price of domestic goods under control. Easy flow of credit keeps the growth mill churning.

On companies: Accretion of reserves has little or no effect on large companies. The higher cost of domestic credit is offset by easier availability of equity capital in the equity market.

The sale of dollars, on the other hand, arrests the rise in interest rates, which benefits small Indian businesses, since they are dependent on loans.

On exporters: Accretion of reserves helps exporters by preventing an appreciation in the value of the rupee. The sale of dollars benefits domestic importers by leading to a cheaper dollar.

On government expenditure: Borrowing-and-investment by the Government of India are adversely affected due to higher domestic interest rates.

The sale of dollars, conversely, helps more investment (and, unfortunately consumption) by the Government of India. To sum up, accretion of reserves benefits the foreign consumer, large industries and exporters, but it hurts investment.

The sale of dollars, on the other hand, is beneficial for the Indian consumer, small industries and importers, and helps investment by the Government of India.

It seems, therefore, that the result of the economic policy is to not export wealth, to reduce the consumption of the Indian consumer, to hurt small industries and throttle domestic growth.

This policy adopted by the RBI is negative. Instead, the RBI should sell dollars and allow the rupee to appreciate. That will control demand side pressures on inflation.

(The author is a New Delhi-based freelance writer. He can be contacted at bharatj@nda.vsnl.net.in)

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