Raghuram Rajan’s balancing act of (im)possible trinity

When Raghuram Rajan took over the charge of the governorship of Reserve Bank of India (RBI), India was facing multiple issues. Because of Federal Reserve bond buying tapering speculation (at that time) hot money started flowing out of the emerging countries and India was no different. In addition to that India's unsustainable current account deficit (CAD) fuelled the bearish sentiment of the Rupee. It was the worst performer among the emerging countries currencies.

Meanwhile, then governor D. Subbarao hiked Marginal Standing Facility (MSF) by 200 basis points to prevent the currency outflow and so called excessive speculation. MSF is the rate at which banks borrow from the RBI in times of tight liquidity and it used to be 100 basis points above repo rate. Markets started speculating about RBI’s next possible move of capital controls, which Finance Minister and RBI governor denied repetitively.

Furthermore, India’s growth rate was (is) at its lowest pace in a decade. Inflation dilemma was continuing due to divergence between high level of CPI and moderate levels of WPI. Everybody was contemplating new governor’s stance on monetary policy at this crucial state of the economy.

Governor Rajan was supposed to prevent free fall of rupee, manage market expectation of not pursuing capital controls and have a monetary policy which is independent of all this. Which is impossible trinity and as name suggest it’s practically impossible to achieve all three at the same time.

In his first monetary policy meeting he took two important decisions.

1. Increasing repo rate by 25 basis points and decreasing MSF rates by 75 points. By doing this he took first step towards managing market expectations of not pursuing capital controls and at the same time he stressed upon the anchoring inflation and inflation expectations. By taking these steps he walked towards achieving two legs of the impossible trinity, i.e. free capital movement and independent monetary policy.

2. Providing the Dollar-Rupee swap facility for dollar funded deposits which helped India to attract nearly $12 billion in less than two months from then. This took care of Indian rupee depreciation and rupee recovered from its lowest levels. Third leg of the impossible trinity talks about fixed exchange rate, in which India doesn’t operate as Indian currency is partially pegged one.

Meanwhile, other factors like tapering postponement and Central government's efforts to curtail CAD also helped the market sentiments.

But credit must be given to governor Rajan as he is doing tricky job of balancing the impossible trinity of free capital flows, exchange rate (managed, not fixed in this case) and independent monetary policy, which is anchoring inflation.