Thursday, December 15, 2011

Interdependence of monetary, trade policy and inflation: time for prioritised policy decision making

News of depreciation of rupee against dollar has been hovering all around for some time. An exchange rate where 1 dollar has become equal to INR 54 has been raising concerns amongst the policy making fraternity. It is raising worries about the state of Indian economy. Depreciation can raise cost of importable items and add to the existing current account deficit of the country. This will therefore affect the balance of trade and can reduce the net earnings of the country from merchandise trade. Further, if many of these importable items are used in the production of domestic goods, then a depreciation of exchange rate can raise the cost of those goods and can further contribute to rising rate of domestic inflation. Rise in the price of domestic edible oils owing to depreciation and contributing to the increase in domestic inflation is an evidence of such a relationship.

Is our country ready to accept such a rise in the rate of inflation owing to the currency depreciation. Before pondering on this, let us try to find out certain causal facts behind this depreciation. According to some experts in the financial sector, this depreciation is happening owing to the rise in buying of dollars by investors following the Eurozone crisis. Increase in the exposure of the Indian economy to the global capital volatility through partial capital account convertibility, complemented by Eurozone crisis can therefore affect exchange rate and capital account with a subsequent impact on the trade balance. Such partial capital account convertibility regimes can also reduce the monetary independence of the country and cushioning of the economy against global capital volatilities.

However, the counterparts will say that capital account convertibility is required to increase capital investments and improve the balance of payments by creating healthy capital account balance.

But in a situation where the world has been witnessing financial and sovereign debt crisis, is it prudent enough to be exposed to such risks! These risks not only affect the trade balance, but can also affect domestic inflation of a country like India at this juncture. So on a priority basis, in the policy making front, certain actions are required. Some of them are listed below -

a) An integration of the monetary and trade policy

b) Reduction of the merchandise trade deficit of India by reducing imports

c) Reduction of the dependence of domestic goods production on importable items in order to delink domestic inflation from currency depreciation.

These measures will have to be taken through lot of coordination across the policy makers dealing with trade, monetary and macro policies. Different ministries and RBI have to be an integral part of this coordination process. In today's context, for an emerging economy like India, any global and national policy challenges have cross cutting influences on each other. So addressal of those challenges need more coordinated and integrated response of policy making to safeguard the country from global risks, continue the domestic growth path as well as maintain the balance of the economy by reducing challenge of inflation that hits pockets of every Indian. But the question is - Are the policy makers listening to this important call for coordinated action?