Friday, May 7, 2010

An Exchange Rate Policy for India

After many attempts at trying to convince the RBI to elucidate the exchange rate policy for India, Mr. A V Rajwade, a noted and respected foreign exchange expert, decided to do it himself. As mentioned in the second of his series (Exchange Rate Policy – II , Business Standard, May 3 2010) this was more of an attempt to describe what the exchange rate policy “should be” rather than what it actually was.

The series, though highly enlightening, falls prey to the same  fallacious beliefs that may have driven India’s exchange rate policy in the years past. I have attempted to address these individually.

1) “In many ways, a carefully constructed Real Effective Exchange Rate (REER) is a reasonable measure of the direction of movement of an exchange rate, and also of its deviation from fair value. (The REER index has some weaknesses but so do all indices used for policy-making — the wholesale price index, the consumer price index, the index for industrial production, etc.)”

The problems with using the REER index as policy input has been discussed at length in an earlier note (Is the REER model of any use?, Business Standard, April 28 2010). In summary, the REER index does not just suffer from normal mathematical & statistical flaws like the other indices mentioned above. It suffers from two fatal flaws which make its output virtually meaningless from a policy making perspective. It can at best be a guidepost, but one which is questioned intensely regarding the impact of its known flaws.

2) “Believers in market efficiency would argue that market prices are self-correcting and that, therefore, the central bank should leave the exchange rate to the market, an argument that is rarely made in relation to the domestic value of money.”

The market is self correcting and the same argument is actually made very often in relation to the domestic value of money. For this to happen, however, there has to be a free market for money, not the current system of fiat currencies with one sole issuer. These arguments are seldom acknowledged by central bankers, past and present, arguably because of the fear of redundancy. Anyway, given the system that exists, since the central bank is the sole issuer of currency, a task that it carries out in a reckless manner sometimes, it is the responsibility of the central bank to manage the consequences of these actions. Also, as an issuer of a currency, it is the central bank’s responsibility to protect its value both internally and externally, a fact that does not seem to figure in any argument put forth in support of a weak currency policy.

3) “Arguably, the exchange rate would be self-correcting if the foreign exchange market were to consist primarily of current account transactions”

“Capital account flows are often cyclical. For example, capital inflows in the equity market would tend to appreciate both share prices and the exchange rate which, in turn, attract more investors thus continuing the cycle, carrying the exchange rate significantly away from fair value.”

The exchange rate would be self correcting regardless of the nature of the flows. In any cross – currency investment transaction, two risks are analyzed. The first risk and one that is given significantly higher weight is currency risk. The second risk is the risk of the asset sought to be purchased, whether Equity, Real Estate or Debt. If the target currency appreciates sharply as a result of capital flows and moves significantly away from its fundamental value, the currency risk for investors would increase significantly, which would lead to an outflow. This would apply the requisite pressure on the currency, which would then depreciate to a level thought to be fundamentally sound. When the RBI intervenes in the market, supposedly to reduce volatility, it insulates foreign investors against their primary risk, which actually leads to an increase in the volume of capital inflows. In one of the few “Growth Oases” left in the world today, insulating foreign investors from exchange rate risk will only increase their willingness to invest, not reduce it. In short, if the aim of our currency policy is to reduce volatility, the outcome will often be the polar opposite. We will have extended periods of calm followed by bouts of extreme volatility due to the build-up of capital inflows and the RBI’s limits in absorbing and sterilizing them.

4) “It is sometimes argued that sterilisation of the excess money supply can lead to an increase in domestic interest rates, which would be detrimental to growth.”

Not only “sometimes argued” but “actually experienced”. The events of 2007 & 2008 bear testimony to the damaging effect of reckless attempts at sterilization in 2008 of an equally, if not more, reckless increase in money supply due to FX intervention in 2007 ( Total FX Reserve increase of approx. USD 95 Bln. through 2007 or close to 10% of GDP). In this case, the manner in which sterilization was sought to be undertaken not only contributed to a severe domestic slowdown, but caused unprecedented volatility in the domestic money market. For close to 2 weeks in October 2008, overnight rates experienced by market participants moved between 0-100%. Volatility of any magnitude in the risk-free rate leads to imperfect pricing of term assets. Volatility of the magnitude experienced then virtually prevented the pricing of term assets. How would the market price a 5 year bond, or even a 3 month commercial paper, if the risk free rate could be anywhere between 0-100%?

The recent demand for interest rate hikes in response to prevailing inflation is another case in point. Thankfully, the RBI has tempered it’s approach, learning no doubt, from its mistakes in 2007/8.

5) “For one thing, if the currency is allowed to appreciate to avoid intervention and sterilisation, this too is a deflationary factor for the economy.”

It would, and in this environment of runaway international commodity prices, thank god! In any case, a deflationary exchange rate policy which precludes the use of domestic monetary policy measures would be a much better way of managing inflation than the current system of inflationary exchange rate policy combined with disinflationary interest rate policy. Monetary policy, which includes the management of exchange rate and interest rate, cannot be conducted in a vacuum. In the current environment of high commodity prices, the conduct of monetary policy has to change from that in the past when the environment was different. While one can argue for a completely free market exchange rate, if the exchange rate has to be managed, it must be done with an eye on the environment. Our existing monetary policy approach seems to be a one-size fits-all approach insomuch as we use similar tactics in a global inflationary environment and a global deflationary environment.

6) “On the other hand, if sterilisation is done through increasing the cash reserve requirement, there are no costs to the central bank — or even to the banking system since the central bank is impounding only the money it had created through intervention.”

This statement is partly correct. There is no cost to the central bank and if one were to take a composite view of the market, the overall cost would be zero as well. However, the market is not one large entity. It is made up of several categories of participants, and even if one were to restrict the scope to banks, several types of banks. When the RBI intervenes in the currency market, it does not buy foreign exchange from all banks in the ratio of their Net Demand and Time Liabilities (NDTL). It buys foreign exchange from banks which have active international banking activities as these are the banks which hold foreign exchange surpluses. And these are the banks which get the injected liquidity. However, when it sterilizes this excess liquidity through a CRR increase, the impact of this is distributed across all banks in the ratio of their NDTL. Obviously there are banks who incur significant costs as a result, but this is balanced by gains made by other banks resulting in zero net cost for the banking system as a whole.

This was also borne out in the liquidity crisis created by this mode of sterilization in 2008, when a couple of disadvantaged banks were driven to the brink of regulatory default, an outcome that would have caused a crisis of confidence in the system as a whole. This would qualify as a low cost option only if we believe in the possibility of “immaculate transfer” of liquidity within the banking system where surplus liquidity would mysteriously flow from a surplus bank to a deficient bank without any cost. Unfortunately, it does not exist and the consequences of such measures are far too frightening to be quantified in terms of cost.

7) “if capital flows continue to surge as many analysts and the International Monetary Fund are expecting, in an extreme situation, one of the three may have to be given up, and it should be the liberal capital account — in other words, resorting to capital controls particularly on portfolio inflows. This is the least costly measure in terms of growth and investment as there is no empirical evidence suggesting that a liberal capital account helps growth.”

By all means! But capital controls on inflows should be accompanied by capital controls on outflows including controls on the import of capital equipment, not just capital outflows in the traditional sense if a repeat of the 1991 crisis is to be avoided. At the root of that crisis was the freedom to import capital goods after 1984 without freeing up of inflows. This led to a situation where negative capital flows added to a negative current account balance, resulting in increased sovereign foreign exchange indebtedness. When this indebtedness reached a point where international investors lost faith in our ability to generate the requisite foreign exchange for debt service payments, they refused further lending.

And if we were to impose these controls on outflows, we would be denying domestic industry the very tools they need to be internationally competitive or the opportunity to buy foreign companies along with their intellectual property, an outcome which cannot be desirable from any perspective.

The one striking aspect of most arguments in favor of the existing interventionist exchange rate policy is the extent to which these are willing to go to preserve status quo or strengthen it. The detrimental impact of attempted sterilization, which has had severe consequences in the not-too-recent past, seems like a minor issue. Capital controls as stated by Mr. Rajwade, or export restrictions and the misuse of our legal system to “arm twist” commodity suppliers as mentioned by Dr. Ajit Ranade (Dancing with the Dragon, Business Standard, April 27 2010), it seems we are now limited only by our imagination.

And all this because we believe that the RBI has a monopoly on the wisdom required to price the rupee.

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