Preconditions for Inflation Targeting in an Emerging Economy: The Case of India Presented By Ankita Mishra Authored By Vinod Mishra & Ankita Mishra Australian Conference of Economists Adelaide, Australia

Outline Of Presentation  Introduction  Objectives  Preconditions for Inflation Targeting  Indian Scenario  Review of Literature  Data and Methodology  Discussion of Results  Conclusions

Introduction Nominal Anchor and Strategies for Controlling Inflation Nominal Anchor: Constraint on the value of domestic money to tie down price level to a specific value at a given time Main Monetary Policy Regimes Exchange Rate Targeting Monetary Targeting Inflation Targeting Monetary Policy with no explicit nominal anchor or ‘just do it’ approach

Introduction (Contd.) Why Inflation Targeting? Enables monetary policy to focus on domestic considerations (unlike exchange rate targeting) does not depend on the stable money-inflation relationship (like monetary targeting) More easily understood by public and highly transparent Allow the monetary authorities to use all available information to decide best course for monetary policy Increases accountability of Central Bank Provides a focus for the expectations of the financial markets and general public and thus allowing Central Bank to respond to short-run developments

Objectives Analysing the applicability of a inflation targeting for a large diverse economy of India  insights on widening the scope of inflation targeting in EMEs Increased integration of Indian economy with world economy  unpredictable inflation India needs a transparent forward-looking monetary policy framework Dearth of literature on applicability and feasibility aspects of inflation targeting for India

Preconditions for Inflation Targeting Independence of monetary policy from 1. Fiscal concerns 2. External Concerns 3. Financial Concerns 4. Structural Concerns May lead to a form of ‘dominance’ over monetary policy and can hinder the use of inflation targeting

Indian Scenario Period (Averages) Seigniorage revenue (as a ratio to GDP) Inflation tax rate Fiscal deficit as a ratio of GDP Net RBI credit as a ratio of GDP Table 1: Fiscal Dominance Measures

Indian Scenario (Contd.) Table 2: India’s Position on External Front Ratio (as % of GDP) to to to Imports Exports Oil imports Short term debt Foreign investment Foreign portfolio investment Foreign direct investment Foreign reserves

Indian Scenario (Contd.) Period (Averages) Capital Adequacy Ratio (CAR) Average No. of SCBs with CRAR Below 10%Above 10% 1995 to to Table 3: Financial Soundness Indicators -1

Indian Scenario (Contd.) IIIIIIIVVVIVIIVIII Period (Averages) Gross NPAs to total assets (In %) Net NPAs to total assets (In %) Deposi ts to total liabiliti es (In %) Lendin g to total Assets (In %) Gross P/L to total assets (In %) Net P/L to total assets (In %) Net interest income to total assets (In %) Borrowings from RBI to total liabilities of SCBs (In %) 1991 to to to 2007/ Table 4: Financial Soundness Indicators -2

Existing Literature Fraga et.al (2003): analysed preconditions for inflation targeting for a no. if EMEs with special reference to Brazil Gottschalk and Moore (2000): analysed efficacy of inflation targeting for Poland by examining the link between instruments of monetary policy and inflation outcomes Debelle and Lim (1999): examined the suitability of inflation targeting for Philippines Hoffmaister (1999): empirical exploration of plausibility of inflation targeting for Korea in a VAR framework

Existing Literature Studies on India Jha (2008), Singh (2006) and Kannan (1999): assessed preparedness of India for adopting IT from financial reforms perspective Khatkhate (2006): suggested IT could work for India and it ought to target headline inflation

Data and Methodology Formulated Sector Specific VAR 1. Fiscal Dominance Issue: three variable VAR with WPI inflation, gross fiscal deficit (as a ratio to GDP) and reserve money growth 2. External Dominance Issue: four variable VAR with CMR,NEER (or Oil prices), WPI inflation and IIP 3. Structural Dominance Issue: three variable VAR with WPI inflation, reserve money growth and supply shock 4. Financial Sector Dominance Issue: CMR, reserve money growth and BSE-Sensex Methodology: Generalized Forecast Error Variance Decompositions

Results Table 5: Test for Fiscal Dominance GFVDs for Quarterly Sample: 1996Q1 TO 2004 Q1 Horizon Shock to M 0 growth Explaining Forecast Error of Inflation Shock to Deficit Explaining Forecast Error of Inflation Shock to Deficit Explaining Forecast Error of M 0 growth Q Q Q

Results (Contd.) Horizon VAR with Exchange Rate VAR with International Crude Oil Price Inflation Shocks to exchange rate explaining Forecast Error for inflation Shocks to exchange rate explaining Forecast Error for interest rate Shocks to oil price inflation explaining Forecast Error for inflation Shocks to oil price inflation explaining Forecast Error for interest rate Table 6: Test for External Dominance

Results (Contd.) GFVDs from a VAR with Supply Shocks Horizon Under HSC IdentificationUnder VSC Identification Supply shocks explaining Forecast Error of M 0 growth Supply shocks explaining Forecast Error of inflation Supply shocks explaining Forecast Error of M 0 growth Supply shocks explaining Forecast Error of inflation Table 7: Test for Structural Dominance

Results (Contd.) Period: 1990:M4 to 1999:M12Period: 2000:M1 to 2005:M3 Horizon Shock to M 0 growth Explaining Forecast Error for BSE Sensex Shock to CMR Explaining Forecast Error for BSE Sensex Shock to M 0 growth Explaining Forecast Error for BSE Sensex Shock to CMR Explaining Forecast Error for BSE Sensex Table 8: Test for Financial Sector Dominance

Conclusions Fading fiscal dominance External dominance not much of an issue at present. But with growing linkage to global economy, there is a need to keep vigil on external sector and continued working towards strengthening the fundamentals Increasing robustness of banking sector and responsiveness of financial market to interest rate impulses Prevalence of Structural Dominance Inflation band targeting with wide target range a better alternative for India Deficit, NEER and international crude oil inflation are important for inflation forecasting