The Hindu Business Line : Rupee rise: Opportunity and challenge?

India's currency policy is still skewed by the 1991 gold-pledging experience, as witnessed by the huge dollar reserves it maintains by subscribing to US T-Bills. The funds could be used better to help promote Indian exports and investments through, say, Exim Bank or IDBI, which would earn us more than the 1.5 per cent on US T-Bills. It is time the currency board mentality was jettisoned, says T. C. A. Ramanujam.

POLICY-MAKERS are confronted by an unprecedented situation. The rupee is rising against the dollar, the euro and the pound sterling. How do we deal with the situation? Does it present an opportunity to spur economic growth?

One of the first lessons in economics is the relationship between exchange rates, interest rates and economic growth rates.

If in India interest rates are in the region of 5 per cent, and US interest rates are at 1.5 per cent, then the currencies must move in a way that there is equilibrium. That is, the Indian currency should fall 3.5 per cent against the dollar, so that an investor who puts money into Indian debt earns 5 per cent and loses 3.5 per cent by depreciation of the rupee.

But what happens if the Indian economy is growing at 10 per cent (in comparison to the 2.5 per cent in the US), and the prospects of growth attract foreign investment on a large scale?

Today, India's imports exceed exports by about $12 billion a year (the trade deficit); and foreign currency inflows have grown from $20 billion in 2003 to nearly $40 billion in the 2004. A situation which George Soros calls "the virtuous cycle" in his book Alchemy of Finance.

The risk-free rate of return in Indian government bonds is 4.5 per cent, even in the short term. The likelihood of the rupee appreciating further is strong, as there is a current account surplus — which means more people are seeking rupee assets and giving up dollar assets to the Reserve Bank of India; in fact, in such quantities that any shortage on account of importing more than exporting is easily made up.

This makes for an easy decision: Do nothing, borrow in dollars at 1.5 per cent, invest in rupees at 4.5 per cent. Earn 3 per cent on the rupee. If necessary, buy a currency hedge for 1 per cent and make a risk-free 2 per cent per annum.

If, however, you are a real businessman, you may not be satisfied with the risk-free 4.5 per cent — not when the real economy is growing at 10 per cent, stocks are booming and there is no real risk of rupee devaluation.

You would take the risk and go for a 10 per cent return. That is the kind of return that the top ten mutual funds in the US would kill for — and all you have to do is buy into India.

What is the virtuous cycle?

If the rupee is strong, and Indian interest rates are higher than the US interest rates, then international investors are encouraged to invest in India

Being a capital-scarce country, investment into India automatically releases money to projects, which spur growth. This makes the currency even stronger.

Ordinarily, the growth would result in a rise in interest rates, but as it is being spurred by inflow of foreign capital, there is really enough money to go around.

The increase in production also keeps inflation low and allows governments to keep monetary policy easy.

In a sense, this strategy is the very opposite of the conventional wisdom that developing countries should export their way to growth, and that export would normally have come by having an undervalued currency to keep exports competitive in the international market.

Is there a contradiction here? Is the strategy of export-led growth and a weak currency keeping exports competitive?

It depends on what one is exporting. If it is textiles or other me-too products that half a dozen other countries export, then a cheaper currency helps — but only until the other countries bring down their currency as well — and the real gainer is the importer.

If, however, exports are in sectors where the competitive edge cannot be easily duplicated, there is no point competing on price — at least not the kind of price advantage offered by the 3-4 per cent devaluation that comes from a weak currency.

The parallel in Reaganomics

In the early 1980s, when Ronald Reagan sought to give a hawkish and rightwing colour to US policy, one of the key policy issues was a strong dollar. From the way Reagan presented it, a strong dollar was a political decision and not an economic one.

At a time when Japanese companies had bought Radio City Music Hall, and GM, Ford and Chrysler were being driven out of the market by Toyota and Nissan, devaluing the dollar seemed the logical way to make the US industry more competitive.

Reagan's power talk about keeping the dollar strong and reducing tax rates to take advantage of the Laffer curve seemed like a bushman's witchcraft. Serious economists labelled the policy package as voodoo economics.

And, surprise of surprises, it worked on faith (or you may call it supply-side economics). This is because foreign investors believed in the dollar as a safe and strong currency and invested in the US. Strong investment flows allowed US industry to modernise and upturn the Japanese tide.

So, is India in a virtuous cycle?

Not yet. We are at the beginning of one. We are, however, still running our currency policy from a "we pledged our gold in 1991" mentality. We keep enormous dollar reserves — money lent to the US government by subscribing to their T-Bills.

If we had the funds, and we used it to replace government debt — the 1.5 per cent interest that dollar funds cost — it could easily go to fund the government, which is even today borrowing from all of us (through banks) at 4.5 per cent.

Imagine cutting the interest burden by half, on new borrowings? Part of the reason for the fiscal deficit coming under control is the fall in rates. But if we want to truly take advantage of the situation, we must invest the dollars available in our economy.

This can happen either by the government launching a number of projects or simply telling the banks that it has a cheaper source of money, and can they please go elsewhere for their returns. After all, banks and financial institutions are supposed to know about funding projects.

Indeed, criticising the "loose-fiscal/tight-money" policy mix followed since 1977, the World Bank points out how banks are happy to lend safely to the Government at high rates and interest rates — higher than they would if the government did some expenditure pruning. (World Bank Policy Research Paper No: 3230, March 2004).

Alternatively, we could use the funds to help promote Indian exports and investments through, say, Exim Bank of India or IDBI. At least, it would earn us more than the 1.5 per cent on US T-Bills.

There is a small caveat here. India is not an economy where the rupee is freely convertible.

This may be a wise policy given the volatility of currency markets. If a free flow of the dollar were allowed into India, it might temporarily depress interest rates. (The RBI today is forced to keep interest rates up, mopping up money by issuing market stabilisation bonds and other similar instruments).

Later on, the money would try to flow out just as fast, and we could have a currency crisis. This is actually one more reason, why, if the RBI feels it necessary to regulate capital flows, it must direct the reserves to the government, which has the ability to, if necessary, set up long-term lines of credit with the IMF, World Bank and export credit agencies such as the US Exim Bank, etc., rather than invest in US T-Bills or their equivalent and thus let governments enjoy the benefit of the capital flows. This currency board mentality must go. Or, at least, ease up a little.