The Hindu Business Line : Making sense of rupee appreciation

It is time India learnt from Japan and China that at the crucial stage of economic growth, an undervalued exchange rate is preferable to an appreciating rate, no matter its advantages in fighting inflation. It is also time the policymakers remembered that exchange rate is not like the price of cabbage that can be left to the pure market forces of demand and supply, say D. SAMBANDHAN and M. RAMACHANDRAN.

In recent months, there has been a great deal of media debate on inflation and exchange rate management. Professional economists, financial analysts and journalists have been articulate in enriching this debate. More importantly, a former Reserve Bank of India Governor has drawn attention to the writings of an economist criticising the RBI's currency policy.

The economist complains that unlike the US Federal Reserve Bank, which has succeeded in containing inflation by raising the policy reference rate seventeen times by 25 basis points each since July 2004 in a more transparent and calibrated fashion, the RBI has been resorting to hikes in repo rate and the Cash Reserve Ratio, taking the market by surprise. The RBI, the economist argues, is yet to learn the art of conducting Monetary Policy in an open market economy.

It is well known that the RBI has been resisting rupee appreciation to avoid any undue erosion of export competitiveness in the face of huge capital inflows. When the country receives more foreign exchange there is a natural market pressure on the rupee to appreciate. However, central banks, in reality, do not prefer currency appreciation as that would make exports costlier. Therefore, they buy foreign exchange from the market by selling domestic currency.

This implies creation of additional money; hence, higher credit growth and inflation. In response, the monetary authority resorts to sale of government securities to suck out the excess liquidity — an operation known as sterilisation. Since the RBI has several constraints in conducting open market operations, CRR and repo rates hikes are resorted to so as to sterilise the excess liquidity.

Does liquidity expansion mean credit explosion?

It may not be right to say that the RBI's exchange rate intervention is responsible for higher money growth. True, monetary expansion is a necessary condition but not a sufficient one for generating inflation as it is multivariate phenomena.

What matters most in the context of inflation, especially when the economy is in full steam, is the quantum of credit and not the level of monetary aggregates. Therefore, one needs to look into the causes of credit expansion rather than trying to establish a one-to-one correspondence between exchange rate intervention and domestic credit expansion.

There are instances to show that even while money growth was sluggish, credit expansion was large, and vice versa. This means the commercial banks can always frustrate the central bank's tight policy measures by reshuffling their assets and liabilities to meet the growing credit demand. Thus, credit growth is largely driven by the growth performance rather than by the liquidity explosion stemming from exchange rate intervention.

Resisting rupee appreciation?

Another criticism is that at a time when the economy is at full capacity, the RBI's currency policy is trying to keep export demand up (by resisting rupee appreciation) and dampening domestic demand down (by hiking interest rate). This action amounts to Indian consumers subsidising their American counterparts and ultimately absorbing the shocks and disturbances of inflation.

To be fair, it is wrong to assert that rupee has not appreciated enough. The very fact that the rupee has moved from Rs 49 to a dollar (2002) to the current level of less than Rs 41, with intermittent ups and downs is a clear pointer that the RBI has allowed some flexibility in the key exchange rate.

Falling in line with international experience, the RBI has taken sufficient care not to allow the exchange rate to wander freely in response to capital flows for the simple reason that this would not only lead to more volatility in the rate but also push it to a level far divorced from the fundamentals, as mentioned by Paul Krugman long ago.

Surely, any incentive to promote exports in the face of supply constraints is not a desirable proposition. But to say that the RBI is deliberately manipulating the exchange rate instrument to prop up export demand, as is often argued, is thoroughly misleading because supply management is not the domain of the RBI.

If only the authorities concerned had learnt the art of managing international trade, that is, what a country should put into the export basket and what it should not, India would not be finding itself in the awkward situation of heightened inflation vis-à-vis certain agricultural wage goods and also manufacturing commodities. Furthermore, to say that domestic demand plus net export demand growing at higher rates leading to inflation is merely a consequence of wrong supply management and it has nothing to do with exchange rate policy.

Merely by manipulating the rupee-dollar exchange rate the RBI cannot enhance the competitiveness of India's exports, because in the post-intervention period, the real exchange rate would appreciate and that will definitely place the exporters at a disadvantage. Indeed, under that circumstance, the rupee needs to depreciate and that is what the RBI until recently has done through intervention policy amidst several constraints, by allowing only modest appreciation.

The RBI's recent move

In recent weeks, the RBI has chosen to remain passive in the foreign exchange market and allowed a sharp appreciation of rupee. What the RBI is now doing is in line with the policy perspectives of central banks such as the European Central Bank, which has allowed the euro to appreciate to tolerable limits; but rupee is not euro and it is not prudent to make the rupee dance to the dictates of global finance at a time when considerable real exchange appreciation has eroded the country's international competitiveness.

The recent policy initiatives of further liberalising capital outflows in select areas do not make sense because monetary tightening has kept interest rate at a high level, leading to renewed surges in capital inflows.

The recent jump in External Commercial Borrowings and other short-term capital flows are a testimony to the futility of liberalising capital outflows. Even if the rupee is allowed to appreciate to cross the psychological barrier of Rs 40 to a dollar, there is no guarantee that the RBI will regain policy autonomy to fight inflation. Thus, it is obvious that there is no soft option to escape the well-known inconsistent trinity.

Rupee needs a cap

The quick climb of rupee in recent weeks, as compared to the modest and gradual of appreciation in the last four years, would only show that left to the market the rupee tends to experience larger swings. An appreciated and appreciating rupee would evoke more capital inflows, which would further complicate monetary management. Already the rupee has emerged a sought-after currency in the Asian market. Allowing the rupee to climb still further would be a prescription for disaster as speculative bubbles would be breathed into it. Therefore, a limit must be set on the rupee in reflecting and respecting both the dollar's weakness and capital flows.

However, the RBI Governor's recent statement that what was considered volatility in the past would now be treated as greater flexibility in exchange rate gives a signal that authorities are quite keen on ensuring price stability and managing capital flows at the cost of exchange rate volatility. While conceding that price stability is an essential precondition for growth, it must be emphasised that exchange rate stability is also equally important to facilitate growth.

Therefore, it is time India learnt the currency lessons from the experience of Japan and China that at the crucial stage of economic growth, an undervalued exchange rate is preferable to an appreciating exchange rate, no matter what its alleged advantages are in fighting inflation. It is also time the policymakers remembered the statement of R. A. Mundell that exchange rate is not like the price of cabbage which can be left to the pure market forces of demand and supply.

(The authors are, respectively, Head, Department of Politics and International Studies, and Professor, Department of Economics, Pondicherry University, Pondicherry. They can be contacted at dsambandhan@rediffmail.com and ramchn2003@yahoo.co.in)