Context

All emerging markets (EMs), including India, are facing outflows of foreign portfolio investment as the US Fed tightens.

Inflatioon and exchange rate

• Exchange rate as response to capital flow: Canonical inflation targeting wants exchange rates to float as the correct response to capital flows.
• Policy should respond to exchange rate fluctuations only after they affect inflation or output.
• Any interest rate defence of the exchange rate would reduce the focus on inflation.
• But most EMs intervene in foreign exchange (FX) markets in order to reduce volatility.
• A research paper by Edward F Buffie and co-authors indicate that  FX intervention greatly enhances the efficacy of inflation targeting.
• Two instruments for two targets work better than trying to do everything through the interest rate.
• Excess depreciation of currency can raise inflation.
• Other researches such as from the IMF, argues for the use of prudential capital flow management techniques and finds reserve accumulation and its use reduces risks and crises in EMs.

Policies followed by RBI to reduce volatility

• Not fully convertible: RBI’s sequenced approach to capital account convertibility, where, for example, debt inflows are only allowed as a percentage of domestic markets, saved it from the kind of interest rate volatility Indonesia experienced during the taper tantrum and is helping it now.
• More liberalisation measures can be taken when needed.
• India’s large foreign exchange reserves have allowed rupee depreciation to be lower than most other countries as the dollar strengthens.
• The cost of holding foreign exchange: There are costs of holding large reserves and of too much intervention.
• The central bank ends up supporting the US and not its own government borrowing and it sacrifices interest income.
• But holding reserves and then not using them when required is the most costly.
• Again use of multiple instruments can mitigate over-reliance on intervention.
• Much research and recent experience suggest that all available instruments should be used to moderate volatility in nominal variables.

Why increasing interest rates will be ineffective in reducing capital outflow

•  A common suggestion is to raise policy rates to maintain a historical gap with US Fed rates.
• But such an interest rate defence did not prevent outflows during the taper tantrum or in 2018 and only triggered a slowdown.
• It forgets that interest-sensitive flows are only about 8 per cent of India’s foreign liabilities.
• There have been no debt outflows in 2022 despite a narrowing interest differential.
• Equity outflows also seem to be tapering.
• Monetary tightening that dampens expectations of growth, induces more outflows as country risk-premiums rise.

Issues with less intervention

• Some want less intervention and more rupee depreciation in order to improve the current account deficit.
•  But less intervention can lead to a chaotic fall and jittery markets as we saw in 2011.
• It is best for policy to prevent over-depreciation due to global risks.
• After about 4 per cent nominal depreciation, India’s real effective exchange rate against a basket of 40 countries is approaching 100.
• That implies the real exchange rate is too depreciated since India has had relatively more structural reform and productivity growth.
• Future corrections toward equilibrium will require a rise of the rupee.
• High oil prices are a risk for India’s balance of payments, but multiple types of adjustments have the best chance of succeeding.

Why sometimes policy changes are introduced as surprise?

• Market participants want clear communication and no surprises for markets.
• Forward guidance is an important part of inflation targeting. But when markets tend to overreact and are influenced more by the US than by Indian policy, the best way to introduce a policy change may be by surprise.
• Thus markets had priced in excessive rate hikes after the US Fed began tightening.
• The steep surprise hike in Indian repo rates prevented additional rate hikes from being priced in as domestic rate-rising began.

Conclusion

Inflation targeting is an art that requires skill, attention to context and an open mind.

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Back2Basics: Real Effective Exchange Rate

• The real effective exchange rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies.
• The weights are determined by comparing the relative trade balance of a country’s currency against that of each country in the index.
• An increase in a nation’s REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper.
• It is losing its trade competitiveness.

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