Column: High-risk policy

There is a perceptible fear among investors and corporates that the Reserve Bank of India's recent tightening of liquidity to protect the currency is a precursor to a prolonged period of high interest rates. To assess how likely that is, it helps to look back at the 1997-98 Asian financial crisis, when the Bimal Jalan-led RBI had shocked the market by raising rates by 200 basis points.

The situation then was eerily similar to what we see now: the economy was suffering from the after-effects of badly planned unviable investments, and inflation had come off, encouraging RBI to ease monetarily. But then some emerging markets (EMs), particularly the South-East Asian economies, after several years of dramatic growth, descended into crises. With Indian domestic demand resilient, and exports falling due to slowing global growth, the current account deficit (CAD) increased sharply at about the time that fund flows dried up. In the month of November 1997, the rupee fell 9%.

In response, RBI applied some band-aid in December by tweaking the norms of export and import financing. But as the crisis spread in Asia, the rupee fell another 4% in the first 15 days of January 1998. Out came the bazooka: a 200 bps hike in the bank rate (the policy rate at that time) to 11% on January 16, 1998. Once the rupee had stabilised at 39-40 levels against the dollar, by March RBI started to reverse this trend, and by end of April the bank rate was back to 9%. Rates continued to fall for the next three years.

What was remarkable was the environment in which this reversal happened, and there lies the lessons for us. FII flows as well as short-term debt remained negative for another two quarters (likely affected by the sanctions imposed post the Pokhran tests in May 1998), and trade deficit only started to fall from July 1998. So why then did RBI reverse its earlier decision?

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