Fallacy 4) "The Rupee exchange rate is market determined"
Every once in a while, with some degree of regularity, the RBI feels the need to tell everyone that the exchange rate for the Indian Rupee is "market determined". I wonder why...
If it was a fact, would such a statement be required? Does Hindustan Unilever's management need to tell us that it's share price is market determined? Or for that matter, any other company whose shares are traded by our equity market. They obviously don't because their shares are traded in a market completely free of their influence.
I wonder how investors would feel about investing in equity shares of a company which not only regulated most of the participants in the equity market, but also had the right to issue shares as it wished, creating them out of thin air, without any asset to back them. I wonder how we would feel if this issuer were to issue shares whenever it felt the need to beat down its share price and keep it at a level which it thought was correct. I would imagine no investor in their right mind would want to touch these shares.
And yet, when the RBI steps in to manipulate the price of the Rupee, we the people; all stakeholders in the value of the Rupee, not only stand by as mute spectators but cheer it on. In the name of supporting exporters and ultimately supporting the Indian economy, we encourage the RBI to reduce the value of our currency any time it feels it's "over-valued". (read Fallacies...I for a more detailed analysis)
Yes, there is a Foreign Exchange market in India and yes, the exchange rate for the Rupee is determined by this market. But is it a free market? The largest participant in this market is the RBI, which steps in to buy foreign currencies whenever it feels that the market is overvaluing the Rupee. To do so, it creates Rupees out of nothing and sells them to buy foreign currencies, reducing the price of the rupee in the bargain. Apart from that, it also regulates almost all participants in the Foreign Exchange Market and works hard to keep entities it doesn't regulate out of it. Since the Rupee is held by every citizen of our country, everyone is affected by it's exchange rate, but strangely has no say in it's management.
Assuming that the RBI has the faintest clue about the "correct" value of the Rupee is another fallacy. Possibly the biggest all of us suffer from. How does the RBI know the value of the Rupee? Can it be calculated like that of an equity share or a mutual fund unit, where you take the total value of assets, reduce liabilities and divide it by the total number of shares/units outstanding to arrive at a specific value? Well, that's not possible anymore as there aren't any assets to begin with. But yet, we believe that the RBI mysteriously knows this value and is also absolutely right in intervening in the market to make sure that it trades at this price.
Of course, they have models that tell them what the value should be, but all these are relative value models which can only ascertain theoretical change in the Rupee's value over a specific time. These models, like Real Effective Exchange Rate or REER, need a correct value to start from which, of course, is the one determined by the RBI. Apart from this, models like REER are inherently flawed because of cause-effect circularity, which means that when a change is undertaken based on the models output, that change itself becomes the cause of imbalance and hence, further change.
If the RBI was a corporate entity, its presence in the market would amount to fraud. Punishable with the highest possible penalty with investors, regulators and politicians all baying for blood. So does the nature of the intervention change because the RBI isn’t a corporate entity?
If not, when do we start baying?