The pretence of control

The pretence of control

There is something perverse about our finance minister telling us that attracting foreign capital to India is a problem—a soak test for the economy.

Massive capital inflows, we are told, are as much of an interference in prudent macroeconomic management as something the dog brings in while cleaning the carpets. Perverse, but not novel. We heard the same talk of controls and even morality during the 1990s in Thailand, Indonesia, Malaysia and South Korea. They had the same urge to defend an exchange rate peg leading to massive inflation in those countries.

The Hong Kong Monetary Authority (HKMA) maintains a fixed exchange rate between the US dollar and the Hong Kong dollar. The European Central Bank lets the euro float freely with the US dollar. The Indian rupee lies somewhere between these two poles, sometimes mimicking a fixed exchange rate and sometimes floating freely (depending whether the Reserve Bank of India, or RBI, intervenes or not). Despite their apparently different regimes, Hong Kong and the Eurozone resemble each other on inflation measures, interest rates and vulnerability to speculative attacks. India, on the other hand, despite a currency regime that often resembles both of these on paper, could not be more different on inflation, interest rates and vulnerability. Moreover, Hong Kong brushed off the 1997 currency crisis much more easily than other countries in the region, though they all had a fixed exchange rate.

How do you explain this? Kurt Schuler, US treasury economist, has proposed (and admitted he is not the first to do so) adding a vertical axis—freedom to trade in currency without major legal impediments—to the regime classification.

If you reorganize different currency regimes along both axes, Hong Kong’s rigid nominal exchange rate and the Eurozone’s free float start to look similar. What matters is, of course, not the nominal flexibility, but the freedom to trade and profit from arbitrage.

In case of a float, the nominal exchange rate (the official rate) tracks the real exchange rate (the price of the currency that clears the market), thus leaving interest rates, monetary aggregates and hence inflation stable, everything else staying the same. The monetary authority can then pursue an independent monetary policy.

In case of a currency board such as HKMA, the market clearing exchange rate may change with capital flows, but returns to closely tracking the official rate due to automatic adjustments in the monetary aggregates through arbitrage. Inflation and interest rates track the respective measures for the anchor currency, thus eliminating any chance of an independent monetary policy.

This somewhat convoluted restatement of the famous impossible trinity problem only highlights the fact that it is not just the nominal exchange rate that matters, but also the flexibility in currency trading—convertibility. Freedom of arbitrage makes even a fixed nominal exchange rate look like a mere conversion of units.

All international economic activity faces costs imposed by real exchange rates, not nominal rates. Exporters, much as they may lament their present nominal losses, would eventually have to face up to the real exchange rate in the form of increased costs of production. Admittedly, even in an inflationary situation, some prices rise slower than others, so the impact of the real exchange rate is different for different exporters. However, in the long term (which is what those who matter would worry about anyway) those who decide will have to face up to the reality that innovation and productivity cause profits, not exchange rate pegs.

Despite RBI’s self-described “calibrated" approach towards capital market liberalization, India already has deepening de facto convertibility as economist Ajay Shah wrote recently. Thus, despite the best efforts of policymakers to convince us otherwise, we are not even in control. Besides, this increases the infeasibility of the exchange rate peg, with inflation forcing RBI to give up defending it at some stage. However, the confusing signals being sent about future policy makes us look like a pot of honey to the speculators and hedge funds we are so afraid of. Remember, although Hong Kong withstood the 1997 crisis, it was attacked due to HKMA’s central bank-like tendency to intervene, and not because of its fixed exchange rate.

Blaming capital inflows for our woes is either incompetent or disingenuous on the part of our bureaucrats and ministers. Liberalization of the capital markets is inevitable. The question is whether we will reach the destination stumbling on our way or discard our illusion of planned progress sooner than that.

Sumeet Kulkarni is a writer on monetary issues who is based in Freising, Germany. These are his personal views. Comment at