Recent developments in India and several other Asian countries provide a ringside view of the dilemmas that policy-makers sometimes face in pursuing monetary policy objectives that have inflation as the primary focus. The strong connection between exchange rate management and inflation was always known. But there have been very few occasions in the recent past when the policy framework was put to such a severe test as now. As the Economic Outlook for 2007-08 points out, macroeconomic policy must work to preserve and strengthen the conditions that favoured robust economic growth, while maintaining monetary and exchange rate stability. Over the past one year or so, there has been a demonstration of how these objectives can be meshed in the pursuit of the larger good. Insofar as inflation was demand-driven, the RBI hiked the interest rate to cool some sectors down. However, capacity additions in several key sectors aided by a lowering of import duties and a stronger rupee helped in curtailing inflation. Yet the rupee appreciation — from over Rs.44 to the dollar to its current levels ranging between Rs.40.30 and Rs.41 — has had some less benevolent consequences. Attention has therefore shifted to the causes that have driven the rupee’s recent strong performance and, in the process, to devising a strategy for harmonising the several macroeconomic objectives.

Like many other Asian countries, India has attracted large overseas investments. However unlike most of them who have large current account surpluses, India that had a small current account surplus is, for a variety of reasons, faced with a widening deficit now. Net capital inflows have been of such a magnitude that the central bank has had to resort to large purchases of foreign currency assets. Such large accumulations of foreign currency assets with the RBI have the direct consequence of increasing the stock of reserve money. That in turn fuels the expansion of bank credit and hence can be inflationary. The solution is not to abandon the RBI’s interventions but to devise ways to minimise the imbalance between capital inflows and current account deficit. The Economic Outlook has recommended three policy options. One is to let the rupee appreciate. Beyond a point, however this can inflict pain on the exporters. The second is to absorb part of the dollar flows and sterilise the excess over what may be considered appropriate. And the third is to encourage outflows by removing procedural impediments and discouraging certain types of inflows. Obviously all the three options will have to be mixed judiciously to achieve the best results.