Sunday, December 30, 2007

SS Tarapore leaves me nonplussed

I recently read a piece by SS Tarapore in IIMA's management journal - Vikalpa (Issue - Apr/Jun 2007) titled - "Impact of Monetary Policy on Bank's Growth Path"
The title is a misnomer of sorts since a substantial part of the article is dedicated to an examination of the recent rupee appreciation and RBI's handling of the same.
Below, I will point out whatever seemed downright incorrect to me in the article.

It is still not clear as to what extent the Indian economy has integrated with the world economy
I see no reason why this shouldn't be clear. As of 2007, gross capital flows amount to a staggering 45% of the GDP. Gross two way flows on both the capital and current account exceed 110% of the GDP!
Tarapore :
Persistent capital inflows into the country could result in an unrestrained monetary expansion and a REER appreciation which in turn is likely to end up in a crisis
How on earth can capital inflows increase the stock of money in the economy? Ironically, it is RBI's attempts to defend the dollar in the wake of capital inflows which is contributing to monetary expansion and not the capital flows per-se.

Also, the comment on REER appreciation is unfounded. The REER is a function of both the nominal rate and the rate of inflation in the economy. If the nominal rupee appreciation can help moderate prices, the REER shouldn't change by much. And it hasn't. Check out this piece by Swami Iyer for more on this.

Now suppose that the RBI does not intervene in the forex market. There would be an unbridled monetary expansion and...an appreciation of the REER
Now, this borders on the preposterous. RBI's vain attempts to defend the dollar and its largely ineffective sterilization attempts are to be blamed for the price acceleration India witnessed in March this year. It seems like Tarapore is inhabiting a different planet.

A real appreciation of the rupee is clearly against fundamentals and is clearly unsustainable as it would imply an over-valuation of the exchange rate.
What does he exactly mean by "fundamentals"? How does one arbitrate on whether a certain rate is overvalued or not? The comment reminds me of the fatal conceit that Hayek once wrote about. The very idea that a handful of "wise" central bankers can figure out the appropriate value of an asset which is traded by millions of market participants smacks of an arrogant condescension towards the market and an exaggeration of a central bank's abilities.

To my mind, the article has far too many open-ended unsubstantiated statements that one would not expect in an academic journal, albeit one published by a Bschool. Please do point out if I've got it wrong anywhere.


Vikalpa is not an academic journal.
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