The debate on exchange rate policy always surfaces during periods of prolonged and undue appreciation. At its centre is the degree of flexibility that is beneficial for the economy as a whole. The issue is not about following a policy of persistent undervaluation a la China—the 1998 shift to a flexible regime is well accepted—but to avoid excessive determination by capital account movements. The issue can be paraphrased as a trade-off between exchange rate deployment to attract foreign capital and macroeconomic stabilization vis-à-vis growth promotion through exports at a critical juncture of global uncertainty and weak external demand. The exchange rate policy of the Reserve Bank of India (RBI) has shown a pronounced tilt towards the former objective over the last year. Coinciding with a change in leadership at RBI itself, does this signal a pro-investor, stable environment—a commitment to financial liberalization through progressive rupee flexibility—to the outside world?
The rebound in the currency from the depths following the September 2008 crisis is truly remarkable (see chart). Although its bilateral value vis-à-vis the US dollar is now oscillating around its decade average, in real terms the rupee level equals the 2007 peaks—when it was boosted by a prolonged surge in capital flows— whether measured by the official RBI or Bank for International Settlements’ (BIS) real effective exchange rate (REER) indices.
The broad equivalence of the rupee’s real value to a cyclical peak—when growth is below trend and on booster pills—raises concerns about currency drivers and their full reflection in exchange rate change. Even assuming a trend appreciation due to structural factors such as productivity growth and so on, the pace of currency normalization—in comparison, prices of stocks, another asset partially predicated on capital inflows, have remained well below their 2007 highs—and its race ahead of the real economy question its fair value. The macroeconomic configuration is significantly inferior to the boom peaks: The brisk export growth of the boom years has reversed into a 5% contraction; and indicators such as fiscal balance, current account, savings and investment rates are down too. In particular, the global external environment, including recovery prospects in advanced economies, is vastly different.
Graphic: Paras Jain/Mint
Time will tell whether the V-shaped recovery of the rupee represents a new regime of higher currency flexibility. But the pattern of currency deployment to realize one or another objective offers some guidance on changing beliefs at the central bank.
The first is the channel through which the growth objective is best realized: augmenting the pool of available capital through the finance channel or by affecting the direct component of aggregate demand— net exports. The weight assigned to the former suggests a conviction that the foreign savings route is superior. The overwhelming evidence is actually to the contrary: The foreign savings-growth relationship is, at best, nebulous, with recent studies showing a negative association. On the other hand, history abounds with instances of exports as a driver of growth. Little wonder that there is serious advocacy of dollar depreciation to help the US economy recover.
The second is about exchange rate-based stabilization. Between October and April, REER appreciation has speeded to an average 2% month on month, alongside accelerating inflation and capital inflows. In the not too-distant past (2007-08), RBI had considered this channel to be fairly ineffective. Its estimated pass-through showed that a 10% appreciation lowered Wholesale Price Index (WPI) inflation by 1.1-1.3%; this would be lower in a slowdown as the exchange rate pass-through to prices weakens when demand conditions are soft and the exchange rate environment is volatile.
The third is a preference for the exchange rate option over interest rate defence/cash reserve requirements in tightening liquidity. The exit roll-out and tough speak of RBI in October had the markets braced for a 25 basis points cash reserve ratio (CRR) hike in November-December, followed by a CRR-cum-interest rate hike in January. The CRR hike materialized in January and interest rate defence in March. The appreciation response—less perceptible, perhaps—has been hyperactive throughout. True, the constellation of macroeconomic conditions is a critical determinant of these choices. But the paradox of small and medium firms—including exporting ones—suffering from a combination of stealthy tightening by exchange rate appreciation and rigidly high lending rates amid an ultra-loose monetary stance of negative interest rates and daily deposits of huge excess reserves by banks is glaring.
Of course, one can only guess a central bank’s mind, so this is as good or bad as guesses go. The worry is that in the medium term, excessive reliance on the foreign capital route to growth might come to mask lack of export competitiveness. It may also skew the industrial structure towards non-tradeable goods geared to the domestic market and sheltered from foreign competition. This is not quite a desirable outcome for India at this stage of development.
Perhaps these are crisis responses wherein flexing a strong currency serves multiple objectives: attracting foreign capital, infusing investor confidence after the fiscal deficit shocker of the 2009-10 budget, offsetting negative confidence shift triggered by rating agencies’ downgrades, providing low-cost funds to firms facing stubbornly high domestic lending rates, and so on. We will know soon, as inflows surge some more.
Renu Kohli was, until recently, with the International Monetary Fund.
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