Why does Arvind Subramanian want India to outsource its monetary policy to the United States?

Arvind_SubrahmaniyamArvind Subramanian, the chief economic adviser to the ministry of finance, has latched on to the finance minister Arun Jaitley’s formula. During the course of the last financial year, given half an opportunity, Jaitley asked the Reserve Bank of India (RBI) to cut interest rates.
Subramanian did the same yesterday when he said: “
They (other countries) are aggressively easing monetary policy,” implying that the RBI should also cut the repo rate soon. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.
Subramanian also went on to suggest that it was time that India started to imitate China on the currency front. As he said: “If you were to ask me how did China accumulate $4 trillion of reserves, it’s essentially buying it to keep the currency very, very competitive. So, it is a lesson for all of us. It is not what everything China does we should we imitate… but that is the lesson we should learn from.”
The above statement is nowhere as straightforward as it looks. Subramanian talks about China having accumulated $4 trillion of reserves in an effort to keep its currency, the yuan, competitive. What does he mean by this? Chinese exporters get paid in dollars (largely). When they get these dollars back to China, they need to convert them into yuan, given that their expenses are in yuan, they need to pay taxes in yuan and so on.
Hence, the exporters need to sell dollars and buy yuan. This would push up the demand for the yuan and lead to an appreciation of the yuan against the dollar. An appreciating yuan would not be good for exporters given that they would be paid fewer yuan when they convert their dollars into yuan.
Let’s consider the case of an exporter who makes a $1 million. If one dollar is worth 6.2 yuan (as it is now) the exporter would make 6.2 million yuan. But if one dollar has appreciated and is worth 6 yuan, then the exporter would make only 6 million yuan, which is lower. Hence, an appreciating yuan hurts.
Given that China is an export powerhouse, in the normal scheme of things, the yuan should have been appreciating against the dollar, over the years. And that would have hurt Chinese exports making them uncompetitive.
But that hasn’t happened. From October 2011 onwards the value of the dollar has ranged between 6.34 to 6.20 yuan Hence, when a Chinese exporter exports he has a fairly good idea of what kind of money he is going to make in terms of yuan. Between July 2008 and May 2010, the dollar was worth between 6.8 to 6.82 yuan.
The question is how does this happen? The People’s Bank of China, the Chinese central bank, keeps intervening in the foreign exchange market. It buys dollars and sells yuan. In the process it ensures that there are enough yuan going around in the financial system, and the value stays stable against the dollar.
Nevertheless, the intervention by the People’s Bank is not free of cost. As Raghuram Rajan writes in
Fault Lines—How Hidden Fractures Still Threaten the Global Economy: “If it[i.e. the People’s Bank] intervenes a lot, the abundance of renminbi[another name for the Chinese yuan] in circulation will push up inflation.”
How does that happen? When the People’s Bank buys dollars, it has to sell yuan. Where does it get these yuan from? It prints them (or these days creates them digitally on a computer). The money supply in the financial system goes up. As a greater amount of money chases the same amount of goods and services, prices go up.
The People’s Bank has to avoid this. So what does it do? It carries out what is known as an sterilized intervention. The central bank also sells government bonds that it holds in its kitty. When it sells government bonds it gets paid in yuan. In the process, the People’s Bank manages to ensure that the total amount of yuan in the financial system does not go up dramatically, after it has carried out the intervention to hold the value of the yuan.
Then there is another problem. The dollars that the People’s Bank ends up holding in its kitty are primarily invested in bonds issued in dollars, which includes bonds issued by the United States government and its institutions.
The People’s Bank also needs to pay an interest on the government bonds it sells to suck out yuan from the financial system. The interest on these bonds needs to match the interest that the People’s bank earns by investing in the United States.
If the interest to be paid on the bonds being sold by the People’s Bank is higher than the interest that the People’s Bank is earning by investing in dollar assets, then there is a problem. As Rajan writes: “If the interest paid on dollar assets is low, while renminbi[another name for the Chinese yuan] interest rates are high, the central bank will effectively be holding a low-yield asset while issuing a high-yield liability—which means it will incur a loss. If this negative spread were multiplied by $2 trillion worth of foreign reserves(not all dollars, of course) that China has, it would blow a gigantic hole into the Chinese budget.” [The foreign exchange reserves are now $4 trillion, hence the hole would be bigger. Rajan’s book was published in 2010.]
This is something that cannot be allowed to happen. Hence what does China do? As Rajan writes: “A direct effect of such a policy is that China mirrors the United States’ monetary policy. If interest rates in the United States are very low. China also has to keep interest rates low. Doing so risks creating credit, housing and stock market bubbles in China, as much in the United States. With little freedom to use interest rates to counteract such trends, the Chinese authorities have to use blunt tools: for example, when credit starts growing strongly, the word goes out from the Chinese bank regulator that the banks should cut back on issuing credit.”
Getting back to the chief economic adviser Arvind Subramanian—what he is essentially suggesting is that like the People’s Bank of China, the RBI should also more actively manage the value of the rupee against the dollar, in order to benefit the exporters.
But as Rajan so beautifully explains in his book, what China has done comes with costs attached to it. The Chinese government has been able to manage the negatives because it can do things which other governments which are democratically elected cannot do.
Further, the Indian government (or the RBI) does not have the same control over banks as the Chinese government does. During the last financial year, many statements were made to get banks to cut interest rates and increase lending. But that never happened. Also, India has a thriving private banking sector, over which the government has next to no control.
To conclude, why does Subramanian want India to outsource its monetary policy to the United States? This is something only he can tell us.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on May 27, 2015