Project on Assessment of Key Issues Related to Monetary Policy
[Source: RBI Report on Currency & Finance 2003-04]

Module: 3 Monetary Policy In An Open Economy

Introduction

The 1990s have witnessed growing integration of goods and financial markets across the globe. With growth in global trade in goods and services outpacing growth in world output, the share of external trade in output has increased further. Opening up of the services to international trade and remittances flows have accelerated the integration process. The opening up of the economy has implications for the conduct of monetary policy as well as the monetary transmission mechanism. In particular, it has rendered economies vulnerable to external demand and exchange rate shocks. This, in turn, has enhanced the possibility of significant changes in trade and other current account flows in a short span of time. This was reflected in the aftermath of the Asian financial crisis when a number of economies in this region had to make substantial adjustments in their current accounts.

A more serious challenge to conduct of monetary policy emerges from the capital account. A distinctive feature of capital flows is the greater volatility vis-à-vis the trade flows. Capital flows in gross terms are much higher than those in net terms. Global capital flows impact the conduct of monetary policy on a daily basis, imparting volatility to monetary conditions. Along with the explosion in financial innovations and the information technology revolution, this has led to the swift transmission of market impulses across countries and a structural change in the process of financial intermediation. All this has fundamentally altered not only the environment of monetary policy formulation but also its instrumentality and operating framework. Monetary policy formulation has become much more interdependent than before across economies and has to factor in the developments in the global economic situation, the international inflationary situation, interest rates, exchange rate movements and capital flows. A stylised fact in regard to many, if not most, emerging market economies (EMEs) is that their external borrowings are usually denominated in foreign currency. Large devaluations not only lead to inflation but can also cause serious currency mismatches with adverse impact on balance sheets of borrowers (banks as well as corporates). A financial accelerator mechanism can exacerbate these effects and threaten financial stability. Accordingly, with the opening up of the economies and greater integration, monetary authorities are no longer concerned with mere price stability. Financial stability has emerged as a key objective of monetary policy.

A more recent challenge in monetary management in EMEs has emanated from a significant increase in capital flows coupled with current account surpluses which have led to large overall balance of payments surpluses in these economies. In their efforts to maintain external competitiveness and financial stability, the central banks in EMEs have absorbed the market surpluses. Consequently, the foreign exchange reserves of the EMEs have nearly doubled in the last seven years. The share of reserves held by EMEs in global reserves has increased from 36 per cent in 1990 to 61 per cent in 2003, with Asian EMEs accounting for much of the increase. The absorption of excess supplies by the central banks has, however, implications for monetary expansion and the objective of price stability. The central banks, therefore, face a trade-off: by preventing nominal appreciation, they may ultimately endanger their primary objective of price stability. Typically, central banks attempt to overcome the policy dilemma by undertaking a variety of operations such as open market sales of government/own bonds to neutralise the expansionary monetary effect arising out of their market purchases. Such sterilisation operations, in turn, have their own limitations and involve costs, especially if external flows are persistent. Globalisation, thus, transforms the environment in which monetary policy operates, throwing up a number of challenges. The foremost challenge is the progressive loss of discretion in the conduct of monetary policy.

Like other EMEs, India too has witnessed a progressive opening up of the economy. External sector reforms were a key aspect of the structural reforms initiated in the early 1990s. While current account convertibility was achieved in 1994, the Indian approach towards capital account liberalisation has been one of caution. Trade openness of the economy has increased significantly. There has been a sustained increase in capital flows and the balance of payments has recorded large surpluses. Since 1993-94, balance of payments developments have thus come to play a dominant role in the conduct of monetary policy. Net capital inflows to India have been largely stable, reflecting a prudent approach to capital account liberalisation with a focus on attracting stable capital flows. Nonetheless, there have been brief episodes of volatility in capital flows and these periods have been associated with volatility in the foreign exchange market. Overall, however, the past decade has seen a significant increase in capital flows and the balance of payments has posted surpluses. External developments have thus been a key driver of money supply. A number of steps were taken to manage the surplus conditions as well as periods of volatility in order to retain discretion over the conduct of monetary policy so as to ensure domestic macroeconomic and financial stability.

Against this background, Section I (articles 2 to 4) of this Module discusses implications of globalisation on conduct of monetary policy. It undertakes a critical assessment of recent trends in capital flows to developing economies and examines factors that have led emerging economies in the recent years to become net exporters of capital to the mature economies. Impact of increased integration on business cycle synchronisation and implications of global macroeconomic imbalances are addressed. The Section also discusses constraints imposed by surges in capital flows on monetary management and the policy options, drawing upon cross-country experiences. Section II (remaining articles) assesses the Indian experience of monetary management in an open economy context. It presents a brief overview of the developments in India's balance of payments to place in context the challenges to monetary policy emanating from an open capital account. Policy responses to manage capital flows during times of volatility as well as times of persistent surpluses are highlighted. As sterilisation through open market sales has been a key instrument, an empirical exercise is undertaken to examine dynamics of the adjustment of monetary base and exchange rate in response to exogenous shocks to net foreign assets. The Section also undertakes a discussion of the efficacy of monetary measures in ensuring orderly conditions in the foreign exchange market. Finally, an attempt is made to measure synchronicity of business cycles in India with its trading partners to examine temporal changes in co-movement.

The decade of the 1990s has witnessed a further spread of globalisation. World trade has continued to expand at a rate higher than that of the world output. A more striking phenomenon during the 1990s was the increased financial openness which has led to a sharp surge in capital flows but with concomitant elevated volatility. Greater trade and financial openness can increase cross-linkages and interdependence between economies. Monetary policy authorities are, therefore, required to make an assessment of these developments on domestic output and inflation in formulation of their policies. As it is, monetary policy operates in an uncertain environment. These uncertainties are exacerbated in an environment of greater trade and financial integration.

A particular aspect of globalisation that has heavily dominated the conduct of monetary policy in the emerging market economies (EMEs) in recent years has emanated from the behaviour of capital flows. Boom-bust pattern of capital flows to the EMEs has brought into sharp focus the constraints imposed by the 'impossible trinity'. The EMEs have been juggling to prevent excessive monetary expansion even as they pursue an open capital account and attempt to modulate the speed of change in the value of the local currency. In the process, the central banks in these economies have mainly relied on sterilisation as the policy response and build-up substantial reserves in episodes of punitive capital flows. Foreign exchange reserves reflect a precautionary demand and self-insurance necessitated by volatility of capital flows. This response of EMEs may be all the more appropriate since capital flows in the past 3-4 years are believed, in a large part, due to "push" factors. Another cause of concern for monetary authorities, at the present juncture, emanates from global imbalances, in particular, the US twin deficits. At some stage, the large US current account deficit would have to undergo correction. The concern mainly arises from the consequences for the global economy that may follow from the adjustment dynamics as the US current account adjusts towards sustainable levels.

Like other EMEs, India too has attracted large capital flows, the effect of which has been augmented, in recent years, by surpluses in the current account. Capital flows have been largely stable, reflecting a cautious approach to capital account liberalisation. Nonetheless, there have been a few episodes of volatility in capital flows. Overall, however, the period since 1993-94 has witnessed persistent surpluses in balance of payments. External sector developments, have, therefore, come to influence dynamics of monetary base and monetary aggregates. A multi-pronged approach has been followed to manage the external flows to ensure domestic economic and financial stability. The key features of the package of measures include: liberalisation of policies in regard to capital account outflows; encouraging pre-payment of external borrowings; alignment of interest rates on non-resident deposits; and, greater flexibility in exchange rate. These measures have been supplemented with sterilisation operations to minimise the inflationary impact of the flows and to ensure domestic financial stability.

Operations involving sterilisation are undertaken in the context of a policy response which has to be viewed as a package encompassing exchange rate policy, level of reserves, interest rate policy along with considerations related to domestic liquidity, financial market conditions as a whole, and degree of openness of the economy. Notwithstanding the large scale of sterilisation operations, interest rates in India have softened across the spectrum.

The recent experience with exchange rates has highlighted the need for developing countries to allow greater flexibility in exchange rates but the authorities should also have the capacity to intervene in foreign exchange markets in view of herd behaviour. With progressive opening of the emerging markets to financial flows, capital flows are playing an increased role in exchange rate determination and often reflected in higher exchange rate volatility. Against this background, India's exchange rate policy of focusing on managing volatility with no fixed rate target while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way has stood the test of time. A key lesson of the Indian approach is that flexibility and pragmatism are required in the management of exchange rate in developing countries, rather than adherence to strict theoretical rules.

In retrospect, thus, the opening up of the Indian economy to external flows had a significant impact on the conduct of monetary policy. First, apart from price stability and credit availability, financial stability has gradually emerged as a key consideration in the conduct of monetary policy. Second, the instruments and operating procedures of monetary policy had to be constantly refined to meet the challenges thrown up by the vicissitudes of capital flows and a market-determined exchange rate. Existing arrangements to modulate liquidity had to be supplemented with innovations such as Market Stabilisation Scheme to absorb liquidity. These refinements coupled with prudential external sector management have indeed helped India to maintain monetary as well as financial stability even as the 1990s witnessed severe financial crises in many developing and emerging economies.