Thursday, February 08, 2007

Govt to let rupee rise to bring inflation down

Economic times reports.

NEW DELHI: The government is plumping for a stronger rupee as the most effective short-term measure to combat inflation, according to sources in the finance ministry. The ministry has already indicated to RBI governor YV Reddy that the government will be comfortable with a stronger rupee. The central bank has been allowing the rupee to appreciate of late.

The Reserve Bank could also resort to a hike in the cash reserve ratio (CRR), as merely tinkering with interest rates at the short end does not reduce the excess liquidity that is feeding inflation, which is currently pushing 6%. The bulk of inflation reflects supply constraints: metal prices are high globally (nearly 30% increase over 12 months in dollar terms) as also food prices (up 13%, again in dollar terms).

The government has taken several supply-side measures to reduce prices: slashed import duties on base metals, cement and wheat, curtailed export of sugar, and imported wheat at zero duty. It is trying to import pulses from Myanmar and Canada and planning to step up open market sales of wheat. However, the price rise has not been contained. Longer term supply-side measures will take time to kick in.

Also, the current price rise is not just a supply-side impact. There’s another villain in this story: the huge amount of foreign capital flowing into the country, seeking to cash in on the India boom. Just over the last one week, $3 billion has come into the country, said the finance ministry official.

When foreign capital flows in, money supply goes up as RBI purchases the inflow, giving rupees in return. RBI seeks to take back this extra money in the system by selling government securities. When the public picks up bonds, the cash flows into RBI, reducing the money supply. But such sterilisation is not complete and external capital inflows lead to a rise in the money supply.

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