Liquidity, exchange rate top RBI's concerns

MUMBAI: The Reserve Bank of India (RBI) will have to address liquidity as well as exchange-rate management continuously to smoothen short-term interest rates, according to Reserve Bank of India deputy governor, Rakesh Mohan. Besides, global developments are expected to play a higher role in the conduct of monetary policy in the days to come.

Speaking at Yale University in the United States, Mr Mohan said, “Going forward, there will be a continuous need to adapt the strategy of liquidity management as well as exchange-rate management for effective monetary management and short-term interest rate smoothening.”

He, however, added that the key questions that the central bank continues to face are what should be the instrument and mode of the liquidity management in the interest of growth and financial stability and how much should capital flows affect exchange rate. And under a freer regime of capital flows, these issues become even more relevant, he said.

Underscoring the relevance of international developments back home, Mr Mohan said, “Global developments are expected to have an increasing role in determining the conduct of monetary and exchange rate policies in our country. In an environment of global convergence, retaining independence of monetary policy may become increasingly difficult, calling for hard choices in terms of goals and instruments.”

As for the monetary policy target, Mr Mohan pointed that India has not favoured the adoption of inflation targeting at the same time, though keeping low inflation is a central objective of monetary policy, along with that of high and sustained growth that is so important for a developing economy. Defending its stand, apart from the legitimate concern regarding growth as a key objective, there are other key factors that suggest that inflation targeting may not be appropriate for India.

For one, unlike many other developing countries we have had a record of moderate inflation, with double-digit inflation being the exception, and which is largely socially unacceptable. Besides, adoption of inflation targeting requires the existence of an efficient monetary transmission mechanism through the operation of efficient

financial markets and absence of interest-rate distortions. Moreover, inflationary pressures still often emanate from significant supply shocks related to the effect of the monsoon on agriculture, where monetary policy action may have little role. Also, in an economy as large as that of India, with various regional differences, and continued existence of market imperfections in factor and product markets between regions, the choice of a universally acceptable measure of inflation is also difficult.

A further challenge for policy in the context of fuller capital account openness will be to preserve the financial stability of different markets, as greater deregulation of capital outflows and debt inflows occurs, Mr Mohan said. He called for more market reforms in both debt market and forex market to address the vulnerability of financial intermediaries.

Though these could “perhaps be addressed through prudential regulations and their supervision; risk management of non-financial entities will have to be through further developments in both the corporate debt market and the forex market, which enable them to manage their risks through the use of newer market instruments,” he said.