The leading issue related to the conduct of monetary policy is that central banks all over the world are implementing monetary policy under a globalized economic environment. Specifically, faster mobility of global financial capital has caused macroeconomic management problems for the central banks especially for that of the emerging market economies. Capital inflow and outflow are exerting significant pressure on both exchange rate and domestic liquidity. The Reserve Bank of India also faces tough task of simultaneously managing exchange rate and domestic liquidity to ensure overall stability in our economy.

            As mentioned, capital mobility poses macroeconomic management problems for exchange rate stability and price stability. Over the last few years, sizable quality of capital inflow has caused the appreciation of domestic currency in most emerging market economies including India. Foreign exchange reserve accretion with RBI from FPI, FDI and ECB inflows is a typical case of an emerging economy situation.

            In our country, in the absence of capital account convertibility, the RBI is procuring dollars in exchange for rupee. Significantly, appreciation of rupees has been checked as a result of the RBI intervention. But the resultant domestic liquidity expansion comes as the unwelcome outcome of the RBI intervention in the foreign exchange market. The RBI has checked appreciation but created potential inflation.

            Now, to mop up the excess money supply created due to foreign exchange inflow, the RBI resorts to the practice of sterilisation. Indeed, sterilisation became the most frequency used mechanism of the RBI in the post reform era to counter foreign exchange inflow induced money supply expansion.

            The last wave of inflation that affected the economy during the initial months of this financial year was driven mainly by demand factors. Precisely, the price level rise was the result of money supply expansion caused by the inflow of foreign exchange assets. According to the RBI sources, foreign exchange inflow related money supply expansion was to the tune of Rs. 6000 crore during December 2006. But the RBI has not resorted to sterilisation to mop up excess liquidity immediately. The result was flooding of money income in the asset market stretching equity prices and sky rocketing real estate prices.

            What caused the RBI to postpone sterilisation for a while? Perhaps, the state of the financial system especially that of the bill market might have compelled to RBI to take such a decision.

            During the early months of 2007, the economy was operating at the boom phase of the credit cycle. Banking system’s credit deposit ratio was a high 73.8%; indicating that they were holding just 1.2% more than SLR requirements in the form of securities. Banks competed to deploy maximum of their resources to the loan seekers especially to retail and housing loan segments. The excess money supply induced by foreign exchange inflow immediately flooded the asset market, because of high income elasticity of demand for equities and real estate. It is only after this, the primary commodity and manufacturing commodity prices of the WPI reflected the general price level rise. The RBI, given the poor position of the bill market, and time lag involved in the use of sterilisation to counter money supply expansion, resorted to the more direct weapon of rate hikes. The dual hike of CRR and repo immediately acted on liquidity. It has to be remembered that a one per cent increase in CRR is equivalent to selling of securities worth Rs. 26000 crore under sterilisation. The advantage of CRR is that it immediately works without any time lag and carrying costs compared to sterilisation.

            Hence, it is obvious that given the absence of a developed bill market, sterilisation is difficult to carry out when the credit-deposit rates of the banking system is very high or when there is credit boom. The prevailing bill market environment has adversely affected the willingness of the RBI to carryout sterilization on an immediate basis in early 2007. This is the core reason for money supply expansion and price level rise in the later months. During this phase, the financial system especially the commercial banks were operating at the opposite end of the narrow banking culture. The RBI always cautioned commercial banks on expanding loans especially to high growth sectors. This warning was not just because of potential asset price bubble or NPA risks but also because of the inbuilt difficulty in carrying out sterilisation based monetary policy during a high credit growth phase.

            Indeed, the RBI can counter appreciation of rupee through dollar purchase to the extent of its intervention in the foreign exchange market. The resultant money supply expansion shall be moped up through effective and timely sterilization before additional liquidity storms into the asset market. But during a credit boom phase, sterilisation is difficult to carryout or works with a widened time lag. Or in other words, the RBI can check the appreciation of rupee but it can’t counter the resultant inflation in an equally effective manner. In essence, there is an appreciation – inflation trade off. This trade-off gets strengthened when there is credit boom supplemented by rapid capital inflows. Thus, the last wave of inflation that affected the economy during April – May 2007, gives a policy message: - the RBI can’t counter appreciation and inflation simultaneously.           

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