Policymakers around the world face a dilemma: controlling inflation or sustaining growth. In the context of Covid-19, it was incumbent on the government to finance the deficit to keep the economy going. This activity was supported by central banks, which lent easy money through quantitative easing, thus increasing the money supply and lowering interest rates.

The Russian-Ukrainian war changed the world economic scenario. Rising commodity and oil prices, coupled with supply-side issues, have pushed up inflation. For India, which is a large importer of rough, consumer price inflation is approaching the 8% mark. The inflation scenario in the United States is no different — registering 8.3% in April, among the highest levels in four decades.

Ostensibly to contain inflation, the Reserve Bank of India (RBI) unexpectedly raised the policy rate by 40 basis points and a day later the Federal Reserve raised the benchmark interest rate in the United States by 50 basis points. The objective of these two central banks is to manage inflation as well as exchange rates as a contributing factor.

Higher inflation expectations due to the war, triggering higher commodity and fuel prices, led to lower purchasing power for consumers. This could prevent industry leaders from investing, leading to a further decline in job creation and growth.

The current inflationary factor has more to do with the shock on the supply side. In such circumstances, it does not make sense to follow a restrictive monetary policy to control inflation. It seems that central bankers are using quantitative tightening to control the value of the exchange rate.

Quantitative tightening in the United States is likely to reduce the Fed’s purchases of government bonds, reduce the budget deficit and appreciate the US dollar against other national currencies. This can accelerate capital outflows from developing countries such as India to the United States, depleting India’s foreign exchange reserves and further depreciating the rupee. The exodus is accentuated by high inflation in developing countries.

In the case of India, the exchange rate is expected to depreciate in the future despite the reduction in the nominal interest rate differential between India and the United States, following the rate hikes. This is due to the high rate of inflation in India, induced to some extent (apart from supply factors) by the liquidity injected into the system during the Covid period.

It should be noted that over the past eight months, India’s foreign exchange reserves have fallen from a record high of $642.4 billion in September 2021 to less than $600 billion in May 2022. As of October 2021 , foreign portfolio investors are net sellers of Indian stocks. market, tanking both the Nifty and the Sensex. And the rupiah has been under pressure, falling below 77 to the dollar a few days ago.

money multiplier

The surprise decision to raise the repo rate is an indication that RBI wants to stop a further fall in the rupee. The size of the money multiplier in India is around 5.5. This means that for every unit of central bank money creation, Indian private banks would generate more bank deposits, which effectively multiplies the currency in circulation by at least five times. Such multipliers effectively discourage the central bank from buying government debt. For every crore of rupees of bonds they buy, at least five crores of rupees would be injected into the system, mainly by commercial banks. This monetary expansion is highly inflationary, with an impact on the depreciation of the value of the rupee.

But there is a better way to arrest this fall in the value of the rupee and contain the budget deficit; this is through the use of the digital rupee. Initially faced with the popularity of private cryptocurrencies, central banks are designing central bank digital currencies (CBDCs) that will completely revolutionize payment systems. China has started experimenting with its digital yuan, the European Central Bank is designing the digital euro, and the Fed is planning to develop its digital dollars.

What if the RBI proposed to impose a 100% reserve requirement on the CBDC? This will imply that commercial banks will not be able to multiply CBDCs and turn them into monetary creation with inflationary pressure on the economy.

The RBI can start selling government bonds and start absorbing Indian currency in circulation. The withdrawal of the traditional Indian rupees reduces the number of rupees in circulation by five times as much as the introduction of the digital rupee increases it. The RBI would trade a money multiplier of five for a money multiplier of one. In Italy, Becchetti and Cozzi recently estimated that the digital euro could neutralize up to 75% of public debt. This will help the RBI achieve the dual goals of controlling inflation and further reducing the decline in the rupee.

Banik is a professor at Mahindra University and Cozzi is a professor at the University of St. Gallen, Switzerland

Published on

May 18, 2022