The IMF hasn’t got its analysis of India’s foreign exchange regime right

Net foreign investment increased from $7.7 billion for the period December-September 2022 to $30.7 billion this year.
Net foreign investment increased from $7.7 billion for the period December-September 2022 to $30.7 billion this year.

Summary

  • The Fund’s remark on India’s alleged departure from a floating rate for the mutual exchange of rupees and dollars is unconvincing. Our external sector metrics did improve during the phase identified by the IMF and RBI’s actions were based on the need to contain extreme currency volatility as a goal.

The International Monetary Fund (IMF) this week said that India’s currency was excessively managed by the central bank in the period December 2022 to October 2023, as the rupee moved in a very narrow corridor. Hence, instead of being a “floating" exchange rate regime, it was a “stabilized arrangement" in that period. As a corollary, the Fund’s suggestion is to move to greater flexibility. This view is not binding on anyone, as is the case with any research work. The IMF, however, has not gotten it right.

In any country, intervention is required when there are extraneous factors causing currency volatility. Letting only the market decide its value under such conditions can cause distortions in the balance sheets of companies and noise in money markets. The period in question has been one of considerable volatility in the global dollar index, as the relentless increase in the US Federal Reserve’s policy funds rate made the dollar stronger, which had negative collateral effects on other currencies. In a globalized setting, such effects cannot be avoided and can at best be mitigated through appropriate intervention.

The IMF view may have been acceptable had the rupee been misaligned with fundamentals. These, interestingly, improved significantly during the period in review, and hence there was little reason for the rupee to decline sharply. Let’s take a look at these components.

First, India’s trade deficit averaged $20 billion a month for this period, compared with $22.1 billion in the year-earlier period from December 2021 to October 2022. Second, our current account deficit for the three quarters ended June 2023, at $27.3 billion, was almost half of the $53.5 billion it was in the corresponding period ended mid-2022. Third, net foreign investment increased from $7.7 billion for the period December-September 2022 to $30.7 billion this year. This was notwithstanding a decline in net foreign direct investment (FDI) by almost $22 billion, which was made up for by increase in foreign portfolio investment (FPI) by around $45 billion. The ultimate indicator of currency health is the forex reserves trend. These rose from $563 billion to $586 billion, a modest increase. Hence, there was some improvement on broad external-sector indicators.

On the other side, there was the external factor of a volatile and strengthening dollar. For a flavour of currency markets, the following needs to be digested. The rupee moved in the range of 81.04 per US dollar and 83.29, which is a band of 2.8%. This is in contrast with wider gyrations seen. The euro-dollar rate moved in a range of $1.0469 and $1.1233 per euro, which is a band of 7.3%. Clearly, this was a major disturbance in the market and could not have been left untouched by central banks. One can also compare the annualized daily volatility of the two currencies. For the rupee, it was 3.4%, while for the dollar, it was 6.7%. In fact, it can be argued that even 3.4% volatility every day in any market is considerably irksome, though much better than the 6.7% witnessed for the dollar.

Therefore, the IMF view looks very feeble once we acknowledge that excess volatility is not something a central bank can ignore. The relative stability of the rupee can be attributed to our fundamentals improving on most scores, though not dramatically. In fact, some part of the reserves would have gone up on account of valuation changes, which had also brought them down after the Ukraine war.

It can be counter-argued that the Reserve Bank of India (RBI) did well to control the imported currency volatility that could have created distortions not just for corporates but also in the money market and come in the way of monetary policy efficacy. This was also a phase when the country’s central bank was battling inflation and had increased its repo rate and maintained an uncompromising stance of “withdrawal of accommodation."

At another level, it can be argued that from the point of view of exports, it would have made sense for RBI to let the market drive the currency, as it would have led to text-book adjustments that improve our external balance. But clearly, that was not the goal of RBI. The intervention was more to reduce volatility and lower the negative impact on the monetary sector, which is the primary domain for central bank attention. At no time was a number for the rupee’s value kept as a goal. The intervention was need based.

It is also curious that the IMF has selectively picked up a set of months in which the rupee moved in a narrow band. This would not really be something a theorist would endorse because one judges central bank actions over a period of time and not during outlier months of extreme volatility in the dollar. What happened was driven mainly by the Fed’s action, as global trade remained stagnant during this phase.

To wrap up, the IMF comment on India’s foreign exchange regime being ‘stabilized’, which is a euphemism for ‘managed,’ rather than ‘floating’ does not sound convincing from whichever corner one analyses the same.

These are the author’s personal views.

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