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Monday, Dec 23, 2002

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Hobson's choice for the Reserve Bank

D. Sampathkumar

THE Reserve Bank of India (RBI) invites market players to take a speculative view on rupee-dollar rates.

The relaxations in exchange control regulations announced by the RBI have been widely interpreted as evidence of a calibrated move by it, towards full capital account convertibility. But equally it can be seen as an invitation from it to players in the foreign exchange market to lend a helping hand in stabilising the value of the rupee against the dollar, which is threatening to get out of hand. Consider the evidence.

In the six weeks between end October and mid-December this year, the RBI's foreign currency reserves increased by $4.396 billion. No doubt, not all of this increase could be attributed to the mopping up by the RBI of dollar and other currency flows into the economy. There is some portfolio appreciation too that is at work here, although its quantum can only be guessed. But it is a safe to say that a substantial chunk of this increase could be attributed to the intervention by the central bank

Anecdotal evidence clearly points out to a phenomenon of sustained intervention by the RBI in the foreign exchange market. This is of course confirmed by details of open market purchases furnished by it in its monthly bulletins. Between April and October this year for instance, the RBI had purchased close to $6 billion in the market.

The reserves of currency assets themselves have gone up by close to $10 billion in the last six months. No doubt, the gap between market operations and accretions to reserves would suggest that there have been non-market factors, besides portfolio revaluation responsible for the growth in reserves of currency assets. But the connection to market operations cannot be ignored.

But whatever be the cause, the increase in reserve currency assets is of an order that is unprecedented in recent years. The increase in the first seven months of the current fiscal equals almost the growth is such assets in the entire year 2001-02.

Foreign currency reserves grew from $39.5 billion to $50 billion, an increase of $11.5 billion. And the year 2001-02 itself has been widely regarded as one of the best years in terms of reserves accretion.

What has this meant in terms of rupee's value against the dollar? The massive intervention by the RBI, evident from the reserves accretion, has succeeded in pushing rupee's value down from 46.72 to a dollar at the beginning of fiscal 2001-02 to 48.90 to a dollar by close of the year.

In contrast, however, the intervention in the first seven months of the current fiscal which corresponds almost to the levels of such intervention in the previous year has not only not caused a decline in the value of the rupee, but has actually caused a modest rise in its value vis--vis the dollar. The rupee has gained roughly 45 paise having strengthened from Rs 48.9 to Rs 48.45. to the dollar.

The story gets even more interesting if one looks at the trend of the last six weeks. Although details of intervention by the RBI in this period is not known, the increase in the size of the reserve currency assets suggests that there has been a similar mopping up operations by the RBI of available foreign exchange as in the past. It is no coincidence that the foreign currency assets with the RBI have gone up from $60.729 billion in the fourth week of October to $65.125 billion by mid December this year.

Two points can be made from the evidence presented here. One, the pace of intervention is accelerating all the time and two, despite such accelerated intervention the rupee continues its relentless upward march against the dollar with the domestic currency having further strengthened to new high of Rs 48.08 to a dollar between end-October and mid-December.

One could list a number of reasons as to why the RBI intervention is increasingly proving to be ineffectual in ensuring stable market conditions for the rupee. The current account balance turning into a surplus in recent times has certainly contributed. That just two years ago, the country recorded a deficit of close to $5 billion on this account means that the RBI has to do that much more make up for this shortfall in dollar demand.

The dollar has weakened relative to stronger currencies such as the euro, which has also had its impact. It has lost close to 15 per cent in the first nine months of the current fiscal. Then there is also the phenomenon of reverse capital flight. With a stable outlook for the Indian currency vis--vis the dollar, money that had flown abroad is coming back in various forms causing additional burden on the RBI to counter it with market intervention if it is not to allow the rupee to strengthen significantly. What all this means is that the external sector of the Indian economy has undergone a structural transformation that the traditional prescription of the RBI as the sole arbiter of exchange rate movement seems no longer to work.

Compounding the problem for the RBI is the impact of its mopping up operations on the money supply. In the last six weeks (November to mid-December), the reserves have gone up by $5 billion. Of this, a portfolio revaluation could only have contributed a small portion of the total as a significant chunk of foreign currency assets are still held by the RBI in dollar-designated assets. We are looking at additional rupee funds being pumped into the economy as a direct consequence of RBI's intervention. That should have translated into approximately Rs 24, 000 crore in additional money supply.

If the trend of inflows were to continue and the RBI were to continue with its policy of mopping up whatever surplus that arise from time to time, then in a whole year we could be looking at the injection of additional money supply of the order of Rs 1, 90,000 crore. This is marginally higher than the money supply added to the economy last year. What this would mean to the level of inflation in the economy is anybody's guess.

The RBI clearly faces a Hobson's choice. Its intervention is increasingly proving to be only marginally effective if at all. But such intervention also carries a heavy price tag in terms of risk of unleashing inflationary pressures in the economy. It clearly needs more players to enter the scene with their speculative views on the economy, oil prices, future growth of domestic and global economy etc, and what that means for the rupee's external parity. But from purely fundamental factors such as exports/imports debt servicing and so on, their capacity to take exposure in the light of their views on the future outlook for the economy/currencies is limited.

The latest bout of liberalisation is an invitation to go beyond the fundamentals and take view on the sentimental or technical parameters.

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