Reform chance for new Indian governor

OMFIF, 30th August 2013

Rupee's fall could spur new monetary initiatives

Raghuram Rajan, the new governor of the Reserve Bank of India, can turn the crisis engendered by the rupee's fall into an opportunity to reform the objectives and the instruments of Indian monetary policy.

A Government of India committee, the Financial Sector Legislative Reforms Commission, has recently suggested that the RBI Act of 1934 be repealed and replaced with a new law more suitable for a modern central bank. Anchoring expectations on inflation would require narrowing the objectives of monetary policy and bringing in financial sector reforms that can strengthen the presently weak transmission mechanism of monetary policy.

The Indian rupee has seen one of the sharpest falls in recent times. Although the path ahead is not easy, reforms that have been delayed in the past are now manifestly necessary. Indians have to recognise that there are structural reasons behind the behaviour of the rupee that go beyond the decline in GDP growth and the large current account deficit.

After the 2008 crisis the currency was largely allowed to float, but the move from a pegged exchange rate was not accompanied by a well-defined nominal anchor that could guide price expectations. Though a floating exchange rate facilitated an independent monetary policy, the policy objective was not clearly articulated.

On a number of occasions the RBI argued that price stability or an inflation target could not be its sole or even main policy objective. The RBI preferred the approach of following multiple objectives.

India has now seen nearly seven years of 8-10% consumer price inflation, higher than RBI's target rate of 4-5%. In recent surveys, inflationary expectations of households have risen to above 10%. The demand for gold, which is largely imported, has risen as households have attempted to hedge inflation, putting pressure on the current account. These imports are effectively capital flight from India. All these factors increase the sense of crisis - but monetary reforms may now rise higher up the policy agenda than would otherwise be the case. The new governor has the chance to show his mettle.