Abstract
The SIIO paradigm is developed further showing how the structure, ideas , and institutions analyzed in Chap. 1 affected Indian monetary policy outcomes. An aggregate demand–supply framework derived from forward-looking optimization subject to Indian structural constraints is able to explain growth and inflation outcomes given policy actions. Exogenous supply shocks are used to identify policy shocks and isolate their effects. It turns out policy was often procyclical and sometimes excessively tight when the common understanding is there was a large monetary overhang. But the three factors that cause a loss of monetary autonomy —governments, markets, and openness—are moderating each other. Open markets moderate fiscal profligacy and dominance. Global crises moderate markets and openness as they encourage greater caution. More congruence between ideas and structure is improving institutions and contributing to India’s better performance.
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Notes
- 1.
The analysis in this section draws on RBI publications including monetary policy statements, speeches by RBI governors and data available on the RBI’s website www.rbi.org.in and is updated from some of my earlier publications.
- 2.
In 2011, for example, an FII could invest up to 10 % of the total issued capital of an Indian company. The cap on aggregate debt flows from all FIIs together was 1.55 billion USD. This was increased to 30 billion to facilitate financing of the CAD. A given percentage of GDP implies very different absolute levels of inflows by the end of a period of rapid GDP growth—the absorptive capacity of the economy also rises. Inflows could only come through FIIs—individuals could not invest directly.
- 3.
A vector autoregression model following Christiano et al. (1999) showed the growth of reserve money better indicates the stance of monetary policy for 1985 M1 to 1995 M12 and call money rate for 1996 M1 to 2005 M3. This supports the changing operating procedure of monetary policy in India from quantity to rate variables. The results of forecast error variance decomposition for the later sub period show shocks to exchange rate as major components of unexplained variance of inflation, movements of credit and money supply growth. These findings highlighted the growing importance of the exchange rate channel. While agricultural shocks were the main driving factor of domestic inflation from mid-1980s to mid-1990s, their explanatory power went down substantially post-reform, with international factors becoming the main inflation drivers (Agrawal 2008).
- 4.
A CAD implies domestic resources are less than domestic requirements and part of domestic demand is leaking abroad since it is met by imports. Including it reduces demand even more as the CAD tends to widen during downswings in India. Goyal (2011b) does a similar analysis for the individual years of external shocks.
- 5.
Dash and Goyal (2000) found monetary policy broadly succeeded in preventing an explosive growth in money supply and reined in inflationary expectations. But by targeting manufacturing prices it harmed real output. Their estimations implied it would be more efficient to target agricultural prices for inflation control. A monetary contraction should be completed earlier than in the past, and should coincide with a rise in food prices. Information available in the systematic structural features was not exploited in designing monetary policy. Policy would then be countercyclical. Reserve Bank monetary control had intensified shocks to real output, while being unable to prevent the expansion of credit in response to a profit motive.
- 6.
GFI (Global Financial Integrity) (2010) estimated that tax evasion, crime, and corruption removed gross illicit assets from India worth USD 462 billion since independence.
- 7.
FX reserves rose to over 300 billion USD in 2011, compared to a paltry 5 billion in 1990–1991. 30 billion dollars were accumulated in just 18 months over January 2002 to August 2003. Other years of large inflows were 2007 and 2010. Outflows occurred after the global crisis in 2008, were soon reversed, but occurred again whenever global risk aversion rose. Arbitrage occurred at the short end when Indian short real rates were kept higher than US rates.
- 8.
Monetary policy shocks were identified using a short-run vector autoregression model. The identification assumption on contemporaneous causality used to isolate the policy shocks was exogenous shocks (foreign oil price inflation and interest rates), and domestic variables (inflation, IIP growth and exchange rate changes) affect the policy instrument variable (call money rates, or treasury bill rates) contemporaneously, but the policy variables affect them only with a lag. All these variables go on to affect gross bank credit and the broad monetary aggregate (M). Domestic variables do not enter the lag structure of the foreign variables since the Indian economy is too small to affect international prices. The RBI’s reaction function or feedback rule to changes in the foreign shocks and non-policy variables determines the setting of the policy instrument variable. The policy shock is the residual from this estimated “reaction” of the RBI. It is orthogonal to the variables in the RBI’s feedback rule. The residuals of the ‘monetary policy instrument’ equation give an estimate of the large monetary policy shocks in this period (Goyal 2008).
- 9.
This chart was part of the background papers prepared for RBI (2011).
- 10.
- 11.
The operative rate went from the reverse repo at 3.25 in March 2010 to the repo at 8.5 by October 2011.
- 12.
This section draws on material from Goyal (2014a).
- 13.
For the year as a whole the CAD was 4.2 % compared to capital inflows at 3.7 %. The RBI’s draw-down of reserves, amounting to 12.8 billion USD, made up the difference. In 2012–2013 the CAD peaked at 4.8 %, before coming down the next year.
- 14.
Debt outflows over May 22–August 26th were 868 USD million for Indonesia, where foreign funding of domestic currency sovereign bonds had been liberalized considerably, compared to 35 USD million for India. So Indonesia had to raise policy rates 175 basis posts post taper-on. IMF (2013) in a regression of domestic on US yields finds a significant coefficient (1.1) for Indonesia compared to insignificant (−0.3) for India.
- 15.
In a sensible application of this logic, the RBI in 2014 disallowed FPI investments in Gsecs of less than one year maturity, in anticipation of possible future taper-related volatility.
- 16.
After zero intervention from January, monthly net purchases in USD million were 10678 over 2007:10 to 2008:10. This switched to net sales of 1505 over 2008:11 to 2009:4 as outflows intensified under the GFC. Average intervention was near zero at monthly net purchases of 285 over 2009:05 to 2011:10. But 2011:10 to 2013:07 saw heavy monthly net sales of 8580.
- 17.
The basic underlying principle is that of UIP, which equalizes the expected returns to holding assets such as bonds in any currency. Since currencies can easily depreciate by 10–40 % in a crisis, short-term interest rates have to rise by as much. On 28th January 2014, even as the policy repo rate was hiked by 25 basis points there were outflows, mostly debt, due to global risk-off from the crash of Argentina’s currency and fears of Chinese credit overstretch.
- 18.
I thank Dr. Y. V. Reddy for this point.
- 19.
Thus in December 2011, the INR remained under pressure despite a reduction in global risk-on due to ECB announcement of support to bank lending and money market activity (see http://www.ecb.europa.eu/press/pr/date/2011/html/pr111208_1.en.html) due to the RBI’s then hands-off policy and reluctance to use reserves, thus necessitating severe market restrictions on December 15th. These brought the INR back from 55 to 50. Adverse tax measures for MNCs in the March 2012 budget triggered outflows and the INR again reached 55, leading to further market restrictions in May 2012.
- 20.
There are indications offshore markets rise with restrictions on domestic markets. According to BIS data net turnover from reporting dealers abroad rose from 5.4 USD billion to 6.1, while that from reporting local dealers rose from 11.5 to 12.5 over the 3 years. OTC FX turnover outside the country rose from 50 (20.8 USD billion) to 59 % (36.3 USD billion) of the total (Goyal 2014b).
- 21.
International, FX markets survived the GFC relatively well partly since boards imposed limits on capital available to traders and they had some liability for losses.
- 22.
- 23.
RBI definitions of reserve money from the components side are: Currency in circulation + Banker’s deposits with the RBI + other deposits with the RBI, and from the sources side: RBI’s domestic credit + Government’s currency liabilities to the Public + Net FX assets of RBI other items. The definitions of broad money from the components side are: Currency with the public + Aggregate deposits with banks, and from the sources side are: Net bank credit to government (Net RBI credit to central and state governments + other banks’ credit to government) + Bank credit to commercial sector (RBI + other banks) + Net forex assets of banking sector (RBI + other banks) + Government’s currency liabilities to the public—banking sector’s net non-monetary liabilities. These were followed in deriving the series given in the tables.
- 24.
In the US, for example, velocity fell until 1948, the period of expansion of banks, and rose after that.
- 25.
A threatened downgrade by credit rating agencies forced a reduction in the fiscal deficit in 2013.
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Goyal, A. (2014). Policy Actions and Outcomes. In: History of Monetary Policy in India Since Independence. SpringerBriefs in Economics. Springer, New Delhi. https://doi.org/10.1007/978-81-322-1961-3_2
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