I was pleasantly surprised, nay shocked, by the Deputy Governor’s statement on TV (last Thursday) in the LBR forum program that the Central Bank has been accumulating Foreign Exchange Reserves to back its domestic asset holdings which includes all that money printing that has taken place in the last ten years with the exception of the two years of Ranil’s regime.

There is some confusion in the minds of the Central Bank regarding the issue of backing money supply with Foreign Exchange Reserves; or is it an attempt to build a defense for the accumulation of Foreign Reserves through borrowing in foreign exchange. Building castles in the sand?  Or is it that the Central Bank is genuinely interested in building up a backing for the currency in Foreign Reserves since the rupee is more or less now pegged to the US dollar and its sustainability will depend on controlling the domestic money supply more rigorously?

Currency Board

During the colonial period when the Currency Board was in operation instead of the Central Bank, the currency issue was 100% backed by Foreign Exchange Reserves. Since the currency was a component of reserve money, in fact the only reserve money, the money supply could not be increased unless Foreign Exchange Reserves increased by an equivalent amount. If the Foreign Exchange Reserve declined, then the Currency Board would have to reduce the currency in circulation which constituted the Reserve Money. Banks decided how much Reserve Money to hold to ensure liquidity to cover any drain on their deposits and there was no Statutory Reserve ratio.  Thus the money supply would be automatically reduced. There was no question of printing money to fund fiscal deficits.

In India up to 1956, a foreign securities to currency ratio of 40% was prescribed by law. But it was abrogated. This opened the flood gates for automatic monetization of the fiscal deficits. But Dr Manmohan Singh, through the Supplemental Agreements with the Reserve Bank of India, gave up the government’s claim to demand the Central Bank to fund the fiscal deficit through money printing.

If our Central Bank wants to go back to the Currency Board days, it has to consider Reserve backing not in terms of Gross Foreign Reserves but Net Foreign Reserves after deducting short-term inter-bank liabilities in foreign currency and short term liabilities on debt as well as portfolio balances in shares held by foreigners. These obviously can flow out in a twinkle. It must also deduct foreign currency deposits and foreigners holdings of Treasury Bills.

A backing of Net Foreign Reserves to Currency of 40% was recommended by the Capital Account Convertibility Committee in India. S.S. Tarapore in his book "Capital Account Convertibility- Monetary Policy and Reforms says "had the earlier stipulation (40% ratio) not been abrogated, an unbridled expansion of currency relative to the reserves would not have been possible in 1990-91 and remedial measures would necessarily have had to be put in place long before the balance of payments situation reached crisis levels. (In July 19991 the ratio fell critically to 14% and there was a totally un manageable situation).’’ 

If our Central Bank is serious about backing the currency by Foreign Exchange Reserves as during the Currency Board days it will have to take several other steps. It is no longer sufficient to back only the currency in circulation since the Central Bank has other monetary liabilities as well. What are they? There are the government deposits with the Central Bank as well as the bankers’ deposits held by the Central Bank which are part of Reserve Money or base money. The Central Bank must back the Reserve Money 100% with net foreign exchange reserves if it wants to adopt anything like the former Currency Board arrangement.

The Central Bank must also give up its power to issue its own securities which it is using to sterilize the inflow of foreign exchange. It must give up sterilization altogether and allow the banks to expand or contract credit according to a multiple of Reserve Money. Then the money supply will automatically adjust to the inflow and outflow of foreign exchange and prevent any worsening of the current account of the balance of payments as happens now with the exercise of discretionary monetary policy by the Central Bank.

The next step is to use any continued inflow of foreign exchange to retire foreign currency debt as it will sooner or later become a problem if and when the foreign inflow dries up. Perhaps a ceiling may be necessary on the backing say 125% so that if the Foreign Reserves go up they will have to be used to repay foreign debt rather than to sell to the inter- bank foreign exchange market. 

As long as the domestic interest rates are high the commercial banks will prefer to lend and expand domestic credit rather than accumulate foreign exchange to speculate on the future course of the rupee. So it will be a win- win situation with inflation coming down and the government forced to restrict its budget deficit to what it can borrow in the domestic money market. This will of course push up domestic interest rates but it will also prevent a drain of capital due to any sudden shocks. 

External deficit impact on the money supply

Economic analysts have pointed out that if a peg is maintained (as the Central Bank is doing now), the reserve money requirement of a country is automatically determined by the peg when the net balance of payments proceeds are converted to rupees. (Subject to sterilization policy)

If money is generated in excess of the peg, by the acquisition of Treasury Bills by the Central Bank, it causes a balance of payments crises and high inflation.

If money created by the peg is destroyed by the Central Bank selling its own securities (as it is doing now) it may create a smaller money supply, which is what is wanted now given the deficit in current account in the balance-of-payments. .

Attracted by the high rates of interest on Treasury bills and bonds and on deposits now allowed to foreigners, foreign funds also tend to gravitate inwards. At first the right reaction to inflow of foreign funds should be jubilation, it would appear; the more foreign funds coming in, the better for the country. But that is not the case. The rupee equivalent of the foreign funds released into the system by the commercial banks and the Central Bank when purchasing them, will only add to the difficulties being experienced from the considerable internal money already in existence. It is driving the high domestic inflation (apart from the rise in world food and fuel prices which are now coming down).

What we need is foreign capital equipment, foreign know-how, and foreign manufacturing techniques – in short foreign real investment. A mere inflow of funds without increased output within a reasonable time span is as bad as the rupees printed by the Central Bank to meet the fiscal deficits created by the government each year. The main aim should then be to slow down the inflow of foreign deposits if we want to control inflation. 

The money supply target should depend on expected growth and the acceptable inflation rate. Can the proposed money supply increment produce lower inflation? The predetermined levels of Reserve Money are perhaps too high considering the expanding deficit in the current account of the balance-of-payments.

The present equilibrium is unsustainable because any increase in foreign exchange inflows will lead to an excess of liquidity. The Central Bank will say it is sterilizing such inflows. Fine, but what is required to correct the current account deficit is to reduce the money supply and inflation which would otherwise flow into more and more imports. Already there is a massive increase in imports this year compared to last year. Fortunately oil prices and food prices are coming down.