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Photo: Reuters
Photo: Reuters

India needs a new strategy for an era of a weakening US dollar

Our forex management needs revision in response to the US Fed’s new monetary policy framework

The speech by the chairperson of the US Federal Reserve on 27 August, while inaugurating the virtual monetary policy symposium held annually at Jackson Hole, marks a radical shift, or, rather, confirms one that has been taking place unofficially, if not quite stealthily, for the last 12 years.

Jerome Powell said that the Fed would target average inflation and that policy decisions would be informed by an assessment of the shortfall from an undefined maximum employment level. This means that interest rates will stay lower for much longer. This is a 180-degree turn from the policy of Paul Volcker in the 1980s that saw real US interest rates spike. That sent the US dollar soaring in the 1980s and cemented its dominance of the post-Bretton Woods world. Therefore, it is logical that this new framework would see the opposite effect on the dollar in the months and years ahead. We should be prepared for prolonged dollar weakness. This has profound implications for India’s foreign exchange (forex) reserve management and currency strategy.

The Reserve Bank of India (RBI) will need to keep buying dollars to prevent the rupee from appreciating and to avoid recognizing losses on its purchase of dollars in the last two years. It might end up being a case of the tiger chasing its tail. It might become the equivalent of retail investors averaging down.

That would erode revaluation reserves. Forex market intervention would allow domestic credit to flow to zombie assets or stock market speculation, or both. Together with non-existent returns on foreign currency assets, holding forex reserves might become an exorbitant burden rather than a sign of strength, as in the past.

To evolve a national consensus on a new forex strategy for India, RBI can do a full-scale comprehensive analysis of the following angles. It can publish a discussion paper, invite comments and then finalize a new strategy.

One: Central bank capital adequacy; because whether RBI intervenes or not, its revaluation losses will rise if the dollar goes into a free fall. In fact, with intervention, RBI will be accumulating more of a depreciating asset.

Two: Trade impact; particularly on India’s oil import bill and exports. Note that export growth is more a function of demand (i.e., income growth in target markets) than of prices, which are influenced by the exchange rate. The most recent evidence from India is the performance of Indian exports in the period between 2002 and 2008 and again in 2010 and 2011. Exports surged despite rupee strength. A global growth boom was the more critical factor for India’s export performance.

Three: India’s balance sheet situation; the International Investment Position (IIP) is just a statement of foreign currency assets and liabilities. A strong currency could be used to improve the external debt situation by paying down debt. Alternatively, the country can examine refinancing costly foreign currency loans at lower rates, or pursue a combination of the two.

Sustained strength in the Indian rupee will be an unusual experience. The last time it happened was soon after the new millennium, when the “India has arrived" story gained traction. India took on too many external liabilities for too little productive payoff. It did not end well. In fact, it is not over yet. We should not repeat those follies. Further, currency strength would run counter to Atmanirbhar Bharat, as it makes imports attractive. So, the government and RBI must act in concert.

The competitiveness of Indian manufacturing must be enhanced through other means. Subsidizing retail and agricultural consumption of electricity at the expense of industrial users must be re-examined. Land-use conversion from agriculture to non-agriculture must be eased, simplified and made less costly in terms of both time and money. Regulatory and compliance burdens must be systematically eased by a time-bound plan, with transparent monitoring and reporting to the public. States must come on board and the Centre should kick-start the process by calling a summit with chief ministers.

Despite the recent re-classification of micro, small and medium enterprises (MSMEs), the new thresholds do not go far enough in incentivizing their growth. They remain growth-unfriendly and need to be revisited. Payments to MSMEs for goods sold and services rendered must happen automatically. Both the government and private sector buyers are guilty. Goods and services tax invoices and the government’s e-procurement must be automatically linked to the Trade Receivables System. It is technically feasible, and should be mandated with severe penalties for non-compliance.

If these changes happen, then India can have the best of both worlds: a strong currency and firm economic fundamentals, with the former reflecting the latter. However, business-as-usual, with RBI resisting a rising rupee, will succeed not in weakening the currency, but hurt the economy in multiple ways.

Covid’s fallout is upending familiar behaviour patterns and policy responses. The sooner we recognize them, the stronger we’ll emerge. I am not sure if there is any other option.

V. Anantha Nageswaran is a member of the Economic Advisory Council to the Prime Minister. These are the author’s personal views.

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