Saturday, 9 April 2016

Sort out the tax maze

Indian Express, 9th April 2016

The government has ordered a probe into the leaks. But there are thin lines between the legal and the illegal.

The Panama Papers reveal that countries with much simpler tax laws, lower costs of compliance and a stronger administrative capacity to enforce laws than India have not been able to prevent the use of tax havens. In India, tax rates are higher, the system is complicated and capital controls restrict foreign financial transactions. Tax havens are more likely to be used not just for illegal activity but even for legitimate businesses.

The government has ordered a probe into the leaks. But there are thin lines between the legal and the illegal. The difference between tax evasion and tax avoidance is one such line. Tax evasion involves not paying taxes on your income and is illegal. Tax avoidance, on the other hand, is about managing your taxes across different tax jurisdictions to take advantage of differences in tax rates, such as corporate tax rates, in tax treatment of different kinds of income, such as capital gains, and in tax treaties among countries. Tax havens such as Panama, the British Virgin Islands and the Bahamas try to attract business by offering low tax rates and easy compliance.

Officials from OECD countries on the Panama list are under public pressure because they have been advocating that tax avoidance, though legal, is cheating. A number of OECD initiatives have been taken to reduce tax avoidance: An agreement on Base Erosion and Profit Shifting (Beps) aims to prevent companies from choosing low-tax jurisdictions to book profits in. The Automatic Exchange of Information (AEOI) framework will facilitate information flows among signatories. The Foreign Account Tax Compliance Act (Fatca) targets non-compliance by US taxpayers and compliant countries have to provide customer information to the US government.

In addition to tax avoidance, as tax havens have laws to ensure greater confidentiality of companies and banking secrecy legislation, the companies may be used for money laundering. In general, there is a widespread perception that offshore companies are conduits for money laundering, illegal transactions, tax evasion or parking unexplained wealth. While offshore companies may be used for illegal purposes, law-abiding citizens may hold them for making investments in other countries to help navigate the complex maze of tax treaties and multiple jurisdictions involved in managing tax liabilities. Hedge funds that manage money in multiple countries often use tax havens to reduce compliance costs arising from different tax treaties among jurisdictions.

The Indian case is more confusing than those of OECD countries. It has been made complicated by a set of tax laws that makes compliance more costly than in the OECD. We rank 157 in the ease of paying taxes. Further, the effective tax on profit is higher: The corporate tax rate and the dividend distribution tax put together make the tax rate on profits nearly 50 per cent. The capital gains tax makes financial transactions even more unattractive. This regime is made more tortuous by an onerous set of capital controls.
As a consequence, companies operating globally have every incentive to set up companies in such jurisdictions.

There are some cases in which the actions are clearly illegal. The first, for example, is when the underlying activity is criminal,
say, drug or arms trade. These activities are covered under the Prevention of Money Laundering Act. As a member of the Financial Action Task Force, India works with other member countries to prevent the use of the proceeds of crime.

The second is when there are cases of tax evasion: A person does not declare to the tax authorities in her home country her income, which is paid into a bank account of her company in Panama, and no taxes are paid. Here, a distinction between tax evasion and avoidance is relevant. If taxes have been paid in the tax haven at its lower tax rate, then there may be no illegality. When India introduces the General Anti-Avoidance Rule (Gaar), some of these activities may become illegal.
The third case is if there is a violation of capital controls. This is an India-specific issue. Under the Liberalised Remittance Scheme (LRS), every Indian resident is allowed to invest $2,50,000 abroad every year. In 2004, the limit was one-tenth of this. Money remitted abroad is from income on which tax has already been paid. If the amount invested abroad exceeds the amount allowed by the RBI, it is a violation of the law.
Fourth, the illegality may be the non-declaration of assets held abroad. A provision in the Finance Bill introduced in 2015 made it criminal not to declare foreign assets in annual tax returns. If the assets held in tax havens have been declared, then it is not illegal to hold them.
OECD countries have simpler tax laws with lower tax rates and lower compliance costs than India and no capital controls. The focus of the authorities is to broadly keep business in the country and to tax the income of its residents. Yet, the Panama Papers show that even with much simpler systems and more effective enforcement, it is a challenge to prevent illegitimate cross-border flows.

In India, it is not just entities engaging in crime and tax evasion that have offshore companies. Reports suggest, for example,
that many Indian technology start-ups are moving their headquarters to offshore locations due to our complexities. These muddy the waters as both legal and illegal activities move abroad.

Looking forward, first, rationalisation of capital controls should be a top priority. Many government reports have laid out the path forward. Second, India must move to a simple tax regime with lower compliance costs. The blueprint is ready in the Direct Taxes Code. When countries with simpler laws and better enforcement are not able to prevent violations of the law, we cannot hope to do so with our labyrinth of capital controls, maze of tax laws and much weaker tax administration.

Thursday, 3 March 2016

La-la land budget

Indian Express, 2nd March 2016

Official GDP data is embedded in its vision and strategy. But the numbers seem wrong.

Finance Minister Arun Jaitley presented his first two budgets amid high expectations. He was supposed to usher in bold reforms, push up investment, revive India's engines of growth and create an environment in which domestic and foreign capital felt confident of investing. The budget speech was expected to outline a roadmap for liberalising the economy. It was hoped to be more reformist than the budget speech of 1991.

Budget 2016 was presented under completely different expectations. Fingers were crossed that Jaitley would not deviate again from the path of fiscal consolidation. It was hoped that the strategy of borrowing more for public investment would not be tried again. Markets prayed that an impending rejig of the long-term capital gains tax was just a rumour.

When the budget was announced, most heaved a sigh of relief. Many bad ideas had been kept out. A few good ideas had crept in. Jaitley decided that it was more important to stick to deficit numbers. There was no mention of the long-term capital gains tax. Public spending was more or less budgeted to be under control. Whether this was done to persuade RBI Governor Raghuram Rajan to cut rates, to protect India's credit rating, or out of genuine concern about the debt-to-GDP ratio, it was a relief.

Some worry that the budget numbers are based on unrealistic assumptions, that these numbers can never be achieved. Others feel that there has been a shifting of budgetary allocation from mundane-sounding heads to more politically correct heads. Still others find that investment in roads and railways will now be done by off-balance sheet borrowing. Yet, on the whole, there is cheer.

The need of the hour is a rate cut. And for that, we needed an announcement of sticking to the path of fiscal consolidation.

It is now hoped that Rajan will cut interest rates, will cut them soon and will cut them by a significant amount. Further, it is hoped that he will ease liquidity in the banking system so that the policy rate cut is transmitted to other interest rates. Lower rates would ease the interest burden on industry and prevent further damage to balance sheets. Hopefully, it will also eventually help spur investment.

Given the poor transmission mechanism of monetary policy and the weak balance sheets of banks, hopefully Rajan will also allow the rupee to weaken. A depreciated rupee would help make imports more expensive and exports cheaper, thus giving a boost to demand for industry.

Other than the impact of the budget on boosting growth through the easing of monetary policy and a more competitive currency, there is little else in the budget that will help push investment. For example, the retrospective tax was not repealed. Only assurances about the good behaviour of the income tax department were given. Similar assurances have been made in the past. The reduction in the corporate tax rate did not take place as promised. There was little progress on disinvestment or privatisation. There was no serious cut in food or fertiliser subsidy. Rural distress and low income growth in the farm sector received significant attention in the budget speech, though, fortunately, not that much in terms of budgeted expenditure.

One explanation for why the economy does not need more reforms could lie in the GDP numbers. The logic seems to be as follows: We've already achieved high growth. GDP growth has now accelerated to 7.6 per cent. The increase in Central government capital expenditure has revived investment. The government converted the difficulties and challenges it faced when it came to power into opportunities. Make in India, Skill India, Digital India and a host of other initiatives have yielded results. We are growing faster than China or anyone else.

Mission accomplished! Now we can turn our focus away from growth to redistribution. The redistribution should be done better, with lower leakages and improved targeting. Money should go to the poor and to farmers. More taxes and more transfers can reduce distress. That is why the focus of the budget is not on reviving investment and growth.

While it is all very good if the GDP numbers could be relied upon to tell us the state of the economy, few today have faith in these numbers. Most of us, including macroeconomists like me who have spent most of their lives studying GDP numbers, no longer understand what GDP in India means. This is not to doubt the CSO's methodology in correctly measuring value-added or its sincerity in deflating it with what it believes is the correct deflator; this is more a case of complete bewilderment.

In the past, when production, profits, wages and jobs grew, GDP growth would be healthy. If production was falling, the GDP would fall. Perhaps it was all a play of a healthy inflation rate in which simple calculations made in our heads would make sense. Today, when the volume index for manufacturing is showing tepid growth, we learn that manufacturing GDP is growing very fast. When the net sales of companies are flat, we learn that wages and profits are growing. When bank credit growth is slow and banks are not lending, we are told we need to deflate them correctly and that will turn bank credit growth upside down.

Regardless of what the GDP numbers say, however much they point upwards, almost everything tells us that the economy is looking down. Focusing on GDP numbers hides the danger that we may be living in la-la land. Unless we acknowledge that there is a problem of slow growth and low investment, we do not worry about how to solve it. Perhaps that is why the budget did not focus on investment revival.

There are a few good initiatives in the budget but none that reflects the urgency of the situation. In other words, official GDP data is embedded in Jaitley's vision and strategy. If the GDP does not reflect the true state of the Indian economy today, these may need a reassessment.

Wednesday, 3 February 2016

Let the rupee slide

Indian Express, 3rd February 2016

The economy is best served by lowering interest rates and blocking protectionism.

In its monetary policy announcement on Tuesday, the Reserve Bank of India (RBI) decided to keep the policy interest rate unchanged. One of the implications of this decision is for the rupee. High interest rates have helped in keeping the rupee strong in recent years. It appears policymakers wish this to continue.

But the recent slowdown in China and the depreciation of the yuan means India's external environment has changed significantly. While two years ago it might have seemed like a good idea to prevent the rupee from weakening, a rethink is now warranted.

In recent months, Indian industry has been facing sharp competition from falling international prices. As the budget-making process starts, demands for tariff hikes will get stronger. Accepting protectionist demands could impact downstream industries and have implications for India's international treaty obligations. Favouring certain sectors, especially those with a few large companies, can make the protection politically difficult.

One example of this is the steel industry where the world's largest producer of steel, China' has seen a slump in demand and has an industry suffering from overcapacity. The Indian steel industry is faced with an onslaught of cheap imports. It has, in response, been pressing for hikes in import duty on steel, imposition of a minimum import price and anti-dumping duties.

It can be argued that the government should do nothing, and allow the Indian consumer to benefit from lower Chinese steel prices. However, it is difficult for the government to ignore the state of the steel industry and job losses. The consequent higher probability of defaults on bank loans by steel companies may also push banks into further trouble.

Already, India is ranked No 1 in imposing the most protectionist measures since 2008. In 2015, India imposed the second highest number of protectionist measures, after Russia. For the fastest growing economy in the world, the policy of greater protectionism is becoming untenable.

We expect that in 2016 the pressure for protectionist measures may increase. Global trade has slowed down to nearly zero per cent growth. As the Chinese economy and Chinese exports slow down, Chinese authorities may to try to help push exports.

For one, the Chinese renminbi was devalued. For years, the Chinese currency had seen pressure to appreciate. The slowdown, the pressure on exports and China's decision to depreciate seem to have set off an outflow of dollars from China. Today, the pressure is for greater depreciation. The pace of depreciation has been slowed by foreign exchange intervention. China has been selling dollars. We have seen a decline in its foreign exchange reserves by $513 billion in 2015. In the month of December 2015 alone, China's reserves fell by $108bn. With higher pressure to increase exports, China may allow the yuan to depreciate more.

The most likely direction of the yuan is downwards. In response, other emerging economies are also weakening their currencies. It is not difficult for an emerging market (EM) to do a currency depreciation in today's environment. It does not require cutting interest rates, out of line with macroeconomic conditions. Global growth has slowed down and commodity deflation is putting downward pressure on prices. Following the increase in US interest rates by the Federal Reserve, emerging economies have been witnessing outflows of capital. This is putting pressure on EM currencies to weaken. Indeed, today it is harder for an EM central bank to prevent a depreciation than to allow it.

If other currencies depreciate, it will further make India's imports cheaper and increase the demand for trade protection. However, tariffs are not the only way to protect domestic industry. As is being seen globally, an alternative approach to raising tariffs to tackle the loss of competitiveness of domestic industry is currency depreciation. In the above example, the impact of a 10 per cent depreciation is equivalent to a 10 per cent tariff on all steel imports. Depreciation increases the price of imported goods.

Last week, when Japan adopted a negative interest rate strategy, currency considerations are understood to have played a significant role. While deflation has been around in Japan for a while, the challenge from the yuan and the decline in commodity prices is new. The cut in Japanese policy rates will, it is hoped, depreciate the Japanese yen and increase import prices.

Today, when other countries are protecting themselves by allowing currency depreciation, should India lean against the wind? Should we combine a strong rupee policy with protectionism?

Allowing the rupee to depreciate has further benefits: It makes all imports more expensive. The government does not have the politically difficult job of increasing tariffs case by case. A weaker rupee would also help push Indian exports.

From 2009 to 2013, in the period of high volatility in the global economy, India had a largely flexible exchange rate policy. Since May 2013, India's exchange rate policy has been to prevent significant appreciation or depreciation. Since the taper talk and expectation of rupee depreciation in May 2013, an increase in interest rates and liquidity tightening have prevented any significant weakening of the rupee. Debt flows have been large as the differential between domestic and international interest rates remains high.

Everyone does not want a weak rupee. Foreign investors applaud the strong rupee policy as it protects their returns. Rich Indians like cheap foreign holidays and imported goods. For some people, a strong rupee is a matter of pride. However, the policy of keeping the rupee strong and combining it with protectionist trade measures is unsustainable. Exchange rate policy and strategy for 2016 cannot be the same as it was before the Chinese story started unfolding. The RBI and the commerce ministry need to be on the same page. The government must take a holistic view of the policy strategy on protectionism, the exchange rate and interest rates. The Indian economy would be better served by lower interest rates, blocking protectionism and letting the market determine the price of the rupee.

Monday, 18 January 2016

Be tight-fisted

Indian Express, 18th January 2016

The 'tight fiscal, easy monetary' policy mix can better address problems that plague private investment.

The finance ministry has stressed that it will stick to the path of fiscal consolidation. This is good news. While a move away from the announced targets to give the economy a stimulus may have seemed attractive in light of the signs of slower growth, the policy would not have been the most suitable for reviving investment, the biggest challenge facing the economy.

After the mid-year review suggested that fiscal targets may need to be revised, many economists emphasised the benefits of staying put on the announced path of fiscal consolidation. First, the debt to GDP ratio would remain under control. Equally important, the finance minister would maintain his credibility, particularly since he has already deviated once from the path. The decision of the government to stick to the path of the announced fiscal targets is good not just in the long run. It is also more likely to help in the short term.

One immediate gain of sticking to the path of consolidation will be to create space for monetary policy easing. The sharp decline in global commodity prices and the slowdown in demand in the domestic economy have reduced inflationary pressures. The policy interest rate - that is, the repo rate - stands at 6.75 per cent. Unlike, say, in Europe, where there is no scope for cutting the policy rate that is near zero, in India, there is ample scope to cut it. But while in principle the policy rate can be reduced significantly, the question is how to give monetary policy the space to do so.

A fiscal stimulus would increase the likelihood of demand rising and pushing up the inflation forecast. While deciding the policy interest rate, monetary policymakers target the forecast of inflation and analyse the pressures of demand on core inflation. With a slowdown in global demand, investment and domestic deman, a greater easing of the stance of monetary policy may be more possible today than perhaps even a year ago. This opportunity could be lost if the government had chosen to pursue a policy of fiscal expansion.

Monetary easing in the last one year has been cautious. A number of factors were responsible for this. One, the United States Federal Reserve was expected to raise interest rates in 2015, which could impact volatility in financial markets, especially currency markets. Two, there was a sharp increase in the prices of food items like onions and pulses, feeding into higher food inflation. Three, right at the beginning of the year, the government moved away from the path of fiscal consolidation. The fact that the policy rate was eased by only 125 basis points over the year, though inflation fell by about 500 basis points, can partly be explained by fears of rising inflationary pressures later. Today, when the Fed has finally raised rates and food inflation is expected to remain within control, deviating from the path of fiscal consolidation could keep fears of inflationary pressure alive and keep monetary easing cautious.

A loose fiscal policy would, therefore, have effectively meant that policymakers would be choosing the "loose fiscal, tight money" policy mix. This is sometimes justified by arguing that, given the poor transmission of monetary policy in India, its impact is limited compared to that of public investment, which involves direct spending by the government and raises demand instantly. While, in theory, this may hold, there are two reasons this may not be true in India today.

First, the capacity of the government to spend is limited. A large share of the capital expenditure allocated in Budget 2015 is yet to be spent. Many good plans have been approved and money allocated, but the shovel is yet to hit the ground. While, in theory, public investment can spur private investment' limited state capacity may be one reason why the magnitude and lags involved may make this strategy less optimal than theory suggests.

Second, private companies are unable to repay the interest on their debt. Banks are increasingly seeing loans get in trouble. High interest rates hurt not just the companies whose revenue growth has fallen sharply but also banks whose stressed assets have been on the rise. For private investment to pick up, companies need to have the ability to borrow, and banks the ability to lend. Raising demand through a fiscal stimulus does not address the balance-sheet stress of companies and banks, while a reduction in interest rates would.

Early in 2015, the government and the RBI adopted inflation targeting as an objective of monetary policy. Inflation targeting is adopted by governments and central banks to tie down their own hands. The benefit of low inflation goes to the elected government that gains by way of providing a low-inflation environment to citizens. While endless arguments can be made about the effectiveness of monetary policy in India, the efficiency of the transmission mechanism, the role of food inflation, and so on, there is little doubt that the objective of low inflation is consistent with the preferences of the bulk of the population. The suggestion made by some economists that the government should rethink and review its commitment to inflation targeting, instead of finding ways to meet it, is unwise.

The best strategy for the government, therefore, lies not in giving up the inflation target, or in changing the measure of inflation adopted, the consumer price index, because it is higher than the wholesale price index, or in changing the glide path towards the target, but in creating the conditions that would keep inflationary pressures down.

In the present context, adhering to the announced path of fiscal consolidation would allow the "tight fiscal, easy monetary" policy mix that is more suited to addressing the troubles that plague private investment. The RBI should respond to this commitment by cutting interest rates. There is clearly no magic bullet for reviving investment. However, a reduction in the interest burden could possibly prevent more companies from going towards bankruptcy. This is a greater need of the hour than higher demand.

Monday, 7 April 2014

No escape from freedom

Indian Express, 3rd March 2014

A closed capital account is not a real option. We should focus on sequence and timing.

In his article, 'Against the flows' (IE, February 24), Gulzar Natarajan said capital controls were good and necessary. Liberalising our capital account, he claimed, will not benefit India either through higher growth or investment. It will only result in currency crises and higher risks, which we cannot manage.

India must, therefore, not liberalise its capital account - even the IMF has endorsed this line of reasoning according to Natarajan. But this argument ignores India's de facto capital account openness, the aspirations of a young and ambitious country, which does not want to go back in time, and the enormous body of evidence on the failure of capital controls as a tool of macroeconomic policy.

Economists like to think that there is a debate about capital account openness and that a decision about whether it should be open or closed is yet to be made. But this is not what happens in the real world. In the real world, a maturing country develops a capable financial system and sophisticated firms. It develops a liberal democracy, where the government is unable to interfere in the freedom of citizens. Once a country reaches this state of maturity, the capital account is de facto open.

Whether some economists think it should be open or not, in the eyes of the top 10 per cent of India - which makes decisions for the bulk of the economy - the capital account is open. To close it requires intruding on personal freedoms, inflicting harm on internationalised firms, and damaging the financial system.

When some Indian bureaucrats have argued in favour of a closed capital account at international forums, they have faced amusement from the audience. No country has taken this idea seriously. This so-called "lesson from the global financial crisis" is something no one is interested in learning. There has been no reduction in capital account openness - either among advanced countries or among emerging markets - after the crisis. The free movement of goods, services, ideas, capital and enterprise across national borders is an integral part of modernity.

Capital controls in emerging economies, where they exist, are like tariff or non-tariff barriers that can be switched on and off. They can be price- or quantity-based. Most evidence shows that these controls have little usefulness, both in terms of the time period for which they are actually effective, and in terms of their macroeconomic impact, which is limited and short-lived.

Advocates of capital controls have argued that their failure to deliver results is because they have been temporary. It is contended that permanent controls, which intrude deeply in the functioning of the economy, would work better. India is a rare laboratory that permits restrictions on capital flows.

The present Indian framework is a complex licence-permit raj. It is unlike what is found almost anywhere else in the world. We, in India, know that complex licence-permit systems always work badly, and are almost allergic to the thousands of pages of detailed restrictions.

Have Indian capital controls been effective? The effectiveness of controls is an often-misunderstood concept. We should measure whether they were able to achieve the objective that they were imposed for. If the all-in-cost ceiling for external commercial borrowings (ECB) was reduced from Libor plus 400 basis points to Libor plus 200 basis points, then the question to be asked is not whether borrowing went down. Instead, it should be whether this decision was able to achieve the objective of the restriction - for example, to reduce net inflows. All too often, companies respond to controls by simply changing the garb in which the same capital flows.

If companies moved from pure debt under ECB to foreign currency convertible bonds, the same money would come into India under a different name. One could then wrongly argue that the controls were effective because flows under ECB declined after restrictions were imposed. But the original objective - reducing overall inflows - was not met. Careful analyses of effectiveness have demonstrated that the Indian framework has not delivered on the objectives of macroeconomic policy.

Natarajan's article is about the least interesting end of the capital account openness puzzle. There are two interesting questions to be asked. First, in what order and sequence should controls be removed? Second, what auxiliary actions should India undertake in order to become resilient to the new challenges that an open capital account introduces? If you have air travel, you will have plane crashes, and the country will need to develop the institutional capability to respond to crises. It is interesting and important to understand the regulatory framework required for aircraft and airports. But surely, nobody would propose that we should not have planes.

This takes us to the territory of technical questions that generally do not fit neatly in opinion pieces. What does prudent foreign borrowing mean? Should rupee-denominated debt continue to be more restricted than foreign currency-denominated debt? How can companies be encouraged to hedge their currency risk? How can we help markets for hedging develop? And so on. These are the interesting questions in the field of capital controls - not ideological sloganeering about whether capital account liberalisation is good or bad.

To a significant extent, this is about generational change. One generation ago, it was interesting and fashionable to discuss whether India should liberalise its capital account or not. Things have changed. We are now a $2 trillion economy, with capable global firms, with aspirations for a sophisticated financial system, with a liberal democracy that makes it infeasible for the government to arbitrarily restrict the freedoms of citizens. In such a country, what merits attention is the sequence and timing of capital account liberalisation, and the establishment of institutional capability for fiscal, financial and monetary policy.

Hold on to interest rates

Financial Express, 1st April 2014

The impact of tighter fiscal and monetary policy on inflation is now visible in the recent price data. Inflation, measured both by the wholesale price index and by the consumer price index, has come down. It may still be too early to cut rates, but RBI Governor Raghuram Rajan can now afford to hold rates unchanged in today's monetary policy announcement. His strategy of an aggressive attack on inflation, despite the scepticism often voiced in the Indian monetary policy debate about the effectiveness of monetary policy, was the right strategy and is yielding results.

Considering that inflationary expectations in India are high and persistent, and could take a while to come down, Rajan should not cut the repo rate as yet. If the WPI inflation measure is the target, there is a case for cutting rates since this has come down sharply. However, the CPI, the target towards which the RBI sensibly appears to be moving, is still above 8% and there is fear that it may go up due to unseasonal rains. Also, CPI based inflation has not remained low long enough for inflationary expectations to fall.

The fiscal and monetary contraction of the last 9 months, as well as the slowdown in the economy, have contributed to the reduction in inflation. In this environment, effective communication by RBI that its focus will be on inflation control, has played an important role. In addition, the setting up of the Urjit Patel committee and its view that RBI should adopt inflation targeting has helped counter some of the traditional RBI view that monetary policy has no impact on inflation, that India has a weak monetary policy transmission mechanism so there is no point in trying to raise rates, that inflation in India cannot be measured properly and so on.

The war on inflation is still not won. The present dip in inflation must be sustained for many months before RBI can relax. Despite the fall in GDP growth, the consequent slowdown in demand, and the fall in commodity prices, Indian inflation is higher than what is seen elsewhere in the world. Inflation in food has contributed most, but inflation in non-food has also been sticky.

Looking forward, there is a contradiction between RBI's aggressive stance on inflation and its intervention in the foreign exchange market. RBI's stance on monetary policy could be undermined by its intervention in the foreign exchange market. In recent weeks, RBI appears to be intervening in the foreign exchange market to prevent the rupee from appreciating. The extent of intervention and its sterilisation is not known yet. If the intervention is unsterilised, then it would lead to an increase in liquidity and would pull down interest rates even without a monetary policy announcement. Indeed since RBI's monetary policy is not conducted only through the interest rate instrument, but also through its intervention and sterilisation, something that the Governor does not announce with the policy stance, it has been seen in the past that while actions on the policy rate move in one direction, the liquidity conditions in the market can move in quite the opposite direction. This was the story of the mid-2000s, when RBI was intervening in the foreign exchange market to combat rupee appreciation and raising the repo rate at the same time to fight inflation. Its intervention was only partly sterilised and was pumping liquidity into the system pushing up inflation. As a consequence, the policy rate hikes were ineffective.

Inflation targeting countries usually solve this problem by adopting a flexible exchange rate. In other words, the exchange rate is allowed to move, while inflation is stabilised. Sometimes there may be occasional sterilised intervention by the central bank. However, central banks that target inflation do not pursue pegged exchange rates for long periods. This means that they do not require resources for sustained sterilisation. While the Urjit Patel committee has proposed that RBI target inflation, it has also proposed that the central bank should get unlimited sterilisation powers. Occasional foreign exchange intervention and sterilisation to contain volatility do not require unlimited sterilisation capacity. If RBI is move to an inflation targeting framework, it cannot plan to do unlimited sterilisation. The People's Bank of China, the Chinese central bank, which targets the exchange rate, has such powers. Other central banks do not have such powers as these are inconsistent with the mandate of inflation targeting. In other words, if RBI is to seriously adopt inflation targeting, it must give up on pegging the exchange rate. Trying to target inflation and exchange rate simultaneously on a sustained basis is inconsistent.

A further consideration in the decision about the stance of monetary policy would be global liquidity considerations. Janet Yellen's recent comments suggest that the US Fed could start raising rates next year. As long as the US monetary policy remains unconventional, i.e., until the time comes when the FOMC discusses and decides policy interest rates rather than the purchase of bonds, it remains in uncharted territory. Low inflation, along with a low current account and fiscal deficit, would be a more prudent policy, as there could be sharp and sudden changes in US and global liquidity conditions. This may prompt RBI to keep interest rates unchanged.