There is a pattern developing among some emerging-market central banks: fear of floating.
Central banks in Turkey, Poland and Brazil have all used monetary operations recently, seemingly to prop up their currencies. And, on Monday, the Reserve Bank of India (RBI) became the latest central bank to join the FX intervention bandwagon after the rupee hit record lows against the dollar.
“The market perception of likely tapering of US quantitative easing has triggered outflows of portfolio investment,” the RBI said. “Consequently, the rupee has depreciated markedly in the last six weeks.”
In a bid to “restore stability to the foreign-exchange market”, the central bank hiked its bank rate by 200bp to 10.25%, in addition to several other measures.
It is very hard to be impressed by the RBI’s de facto currency targeting, as there are hardly any economic arguments for its actions. Whatever motivated it, we can safely conclude that the RBI has just implemented significant monetary tightening.
There might be an argument for tighter policy in India, as nominal GDP has risen much more sharply than the earlier NGDP growth trend of around 12%. Furthermore, there is nothing optimal about a 12% NGDP growth path. In fact, I believe that the RBI if anything should target an NGDP growth path around 7% to 8% (as I have argued earlier).
The problem with the RBI’s recent actions is not necessarily the decision to tighten monetary policy, as such, but rather the fashion in which it is done.
The RBI’s decision has clearly not been based on a transparent and rule-based monetary framework.
Hence, after years of high NGDP growth and high inflation, the RBI suddenly slams on the brakes — and not to hit an NGDP level target or an inflation target, for that matter, but to “stabilise” the currency.
The result of this currency “stabilisation” might be that the RBI will be able to curb the sell-off in the rupee (I doubt it), but we can be pretty sure that the cost of this “operation” will likely be a fairly sharp slowdown in Indian real (and nominal) GDP growth. You have to choose — either you have a stable currency or stable macroeconomic conditions. I fear that the RBI has just sacrificed macroeconomic stability in an ill-fated attempt to stabilise the currency — at least if the RBI insist to continue the policy of FX intervention.
In a sense, the RBI has been pursuing monetary policies that are both too easy (too high NGDP growth and inflation) and, at the same time, too tight (in the sense of an abrupt monetary contraction to prop up the rupee). This is the core of the problem — the RBI’s counterproductive stop-go policies.
The way forward
In my view the RBI urgently needs give up its policy of fiddling with the currency and instead let the rupee float completely freely and instead announce a target on the nominal GDP level.
In my view, the historical trend of 12% NGDP growth is too high and a lower NGDP growth target of 8% seems to be more appropriate. The RBI should hence announce that it will gradually slow NGDP growth to 8% during a five-year period. It is important that this should be a level target. Hence, if growth is faster than 11% in 2014, then it is important that NGDP growth will have to be even slower during the next four years. That is exactly the idea with a level target — you should not allow bygones-to-be-bygones. After 2018, the RBI will keep NGDP on an 8% growth path.
Such a policy will ensure a lot more nominal stability than historically has been the case and therefore also very likely significantly increase macroeconomic stability.
Furthermore, a side effect will be that the rupee likely will be more stable and predictable than under the present stop-go regime as FX volatility, to a very large extent, tends to be a result of monetary disorder.
Lars Christensen has been blogging since 2011 at www.marketmonetarist.com, now one of the leading international blogs on monetary policy. He is also chief analyst and head of emerging markets research and cross-asset allocation at Danske Bank in Copenhagen.
