The Hindu Business Line : Go to the root of currency instability

It is foolish to defend currencies without addressing the sources of instability in the real economy, which make asset markets unstable. And hiking interest rates to strengthen currency values is as pointless as rolling back rates to rein in a soaring currency, argues G. RAMACHANDRAN.

Currency stability is a vital economic objective. At the level of the money economy, it makes the conduct of Monetary Policy easy. Monetary planning becomes simple, and interest rates less volatile. Central bankers adore currency stability. They hate turmoil in the currency market. But they naively assume that the cause for the turmoil is the `market' and not the `currency' itself. So, they manage the market.

At the level of the real economy, currency stability has far-reaching consequences. First, it smoothens production and consumption. It takes the potholes out of the supply side. It takes the wrinkles out of demand. Second, it supports capital investments and allocation. Currency stability gives long-distance vision to risk-takers. It supports even-handed allocation of capital. Third, it makes inflows of foreign direct investment less jerky.

Instability, not an option

From the above, it would be reasonable to assert that currency stability is non-negotiable. Currency instability is not an option. There is no good reason why an economy should suffer currency instability. It would be very difficult to defend any policy that promotes currency instability.

But is currency stability such a sacred objective that an economy should volunteer to give its right arm for it? Is it so indispensable that an economy should choose to shoot itself in both legs? Should an economy amputate its limbs to make a currency stand erect, without a wobble?

Macro-finance offers a wholly different view of currency stability. Its first argument is that it may be worth the while to accept the wobbles without having to numb the limbs temporarily. Its second argument is that vital limbs should not be amputated for the sake of currency stability. Macro-finance is an evolving area of intense interest. It is driven by three principles. First, prices of financial assets are driven by macroeconomic events. Second, developments in assets market have profound effects on the aggregate economy. Third, financial and macroeconomic volatility have an impact on the aggregate economy.

Macro-finance is a powerful tool to analyse the consequences of monetary and fiscal policies on investments, asset values and consumer spending. Its focus is the interaction between the macro-economy and financial markets. It examines the causes, the effects and the events in between. Therefore, it has followers in academia, in investment banking and, of course, in central banking.

Macro-finance can be used to examine the effectiveness of some of the popular methods that constitute currency management. The British pound crisis in September 1992 and the Indian rupee crisis in January 1998 best showcase the methods.

There is a widely held view that raising interest rates leads to the strengthening of a currency. If the pound sinks, raise interest rates. If the rupee sinks, raise interest rates. There is another widely held view that intervention by the central bank will save a sinking currency. If a domestic currency sinks, sell foreign currencies and buy the domestic currency. Researchers have developed intervention algorithms that serve to reduce volatility. The algorithms involve an explicit reserves policy.

When the pound wobbled

September 16, 1992 was Britain's Black Wednesday. The pound was frantically sold on the currency markets. The then Prime Minister, Mr John Major, and the then Chancellor of Exchequer, Mr Norman Lamont, tried all day to prop up a falling pound. Mr Lamont did exactly what the naïve expected him to do. First, he did not pay attention to why the pound was being sold (see Business Line, March 29, 2006). Second, he thought that raising interest rates would save the pound. Third, he sold Deutsche marks to buy the pound.

Mr Lamont raised interest rates from 10 per cent to 12 per cent, and then to 15 per cent. He also authorised the spending of billions in reserve currencies — the Deutsche mark in particular — to buy up the sterling. Yet nothing happened. Britain withdrew from the European Exchange Rate Mechanism (ERM). The Chancellor set the interest rate at 12 per cent soon after the withdrawal. The one-month `market interest rate' declined on its own to 6.98 per cent on December 31, 1992; yet the pound did not sink any further. The market, as always, won.

When the rupee wobbled

On November 21, 1997, when Dr Bimal Jalan took over as the Governor of the Reserve Bank of India (RBI), the rupee dropped to Rs 37.42 per US dollar. The East Asian crisis and the likelihood of the Lok Sabha being dissolved then pushed it to Rs 38.52. The RBI then spent around $3 billion to stem the fall. The rupee sank to Rs 39 per US dollar.

When the rupee fell below Rs 39, the RBI raised the cash reserve ratio (CRR) to 10 per cent. Two days later, the Lok Sabha was dissolved and elections were announced. The rupee fell further to Rs 39.90 per dollar. The business media described the declines as a free fall triggered by the market's self-fulfilling prophesies. The market was blamed.

When the markets drove down the rupee to Rs 40 per dollar on January 14, 1998, the RBI increased both the Bank Rate and the Cash Reserve Ratio. Overnight interest rates zoomed, but the rupee did not. US dollars did not gush into India.

Three assertions

Naïve assumptions about restoring stability to the pound and the rupee did not work. Macro-finance has three assertions and a holistic explanation. The assertions come first. First, currencies are an integral part of the asset market.

The values of currencies cannot be separated from the values of assets. After all, money is a medium of exchange first, then a unit of account, and lastly a device for storing value. The storing of value is not money's principal role.

Second, the total supply of money assets is a tiny fraction of the total stock of physical and financial assets. Therefore, the instability of asset values passes more forcefully, quickly and easily into currencies. Thereby, currencies become unstable. But the managed stability of currencies cannot pass as easily, quickly and forcefully into other assets that are unstable.

Third, it is wholly foolish to defend currencies without first addressing the sources of instability in the real economy. Instability in the real economy leads to instability in the asset markets. Currency instability follows. It is merely a manifestation of the effects of deeper causes outside the currency markets.

A holistic explanation

Currency values do not stiffen when interest rates are raised. The reason should be obvious from the perspective of valuation of assets and the demand for currencies. First, when interest rates are raised, free cash-flows of firms and farms decline. Free cash-flows from commercial and residential properties decline. Call this the numerator effect.

Second, when interest rates are raised, the discount rate or the required rate of return rises. The higher rate is inserted into the denominator in discounted cash flows (DCF) analyses. Call this the denominator effect.

Third, when the numerator shrinks and the denominator expands, the quotients from the DCF analyses shrink. Asset values then fall. Assets become cheaper even as money becomes costlier.

Fourth, rupee prices of assets in India decline when rupee interest rates are raised. Foreign investors — who are supposed to be attracted to the higher interest rates in India — will now require fewer rupees to buy equities, bonds and legally permitted physical assets.

Fifth, the demand for the rupee declines for a given supply of equities, bonds and physical assets. Foreign investors, therefore, need to bring in fewer dollars into India to invest into a given supply of buy equities, bonds and physical assets. When the dollar's relative purchasing power rises, can the rupee strengthen? No, it will weaken.

Therefore, raising interest rates to defend a falling currency is a colossal error. It exacerbates the fall. Similarly, rolling back interest rates to pull down a soaring currency is a colossal error.

From the perspective of macro-finance, using interest rates to manage currency instability is an inapt game.

(The author is a financial analyst. Feedback may be sent to indiagrow@yahoo.com and pari@thehindu.co.in)