The Hindu Business Line : Forex as a monetary tool

To save itself the problem of stabilising the foreign exchange market at a cost, the Reserve Bank of India can use the Capital Outflow Mechanism. If the capital outflow can be augmented, the problem of excess liquidity will be automatically solved.

The Reserve of Bank of India, pursuing a growth-oriented policy with a careful watch on inflation, has been moderating liquidity throughout 2006-07 and 2007-08 by raising the repo rate and the Cash Reserve Ratio.

By raising these key rates the central bank expects loans, especially for real-estate and housing, to become costly, and thus control money supply. The RBI has also been tightening the flow of bank credit to the commercial sector.

The RBI's Annual Credit/Monetary Policy statement, while maintaining these measures, has also tried to operate through foreign exchange reserves.

Broadly, the sources of money supply are Net bank credit to government; bank credit to commercial sector; net foreign exchange assets of the banking sector; and net non-monetary liabilities of the banking sector. The RBI is focussing on using the net foreign assets of the banking sector as an instrument to reduce the money stock.

Though the central bank has been resorting to the Market Stabilisation Scheme to neutralise money expansion due to foreign inflows, this is the first time it has moved boldly to increase the outflow of forex reserves.

Thus, to reduce money supply as well as take yet another step towards fuller Capital Account Convertibility the RBI has taken the following steps.

It has: Liberalised overseas investment norms (for joint ventures) by Indian investors, increased the limit of portfolio investment from 25 per cent to 35 per cent of net worth of companies; upped mutual funds' overseas investment limit to $4 million from $3 million, raised the pre-repayment limit of external borrowings to $400 million from $300 million, and allowed individual investors to remit up to $1,00,000 for the financial year for any current or capital account transaction or a combination of both.

The RBI has also provided hedging facilities in terms of price risk or domestic purchase and sale. In many cases, authorised dealers have been permitted to allow Indian companies remit more foreign exchange for donations, consultancy services, for pre-incorporation expenses and for the purpose of oil exploration.

The increased outflow should act as a counter to the expansion of reserve money by the RBI and finally on the growth of overall money stocks (M3).

The RBI has also observed that "Growth in Reserve Money during 2006-07 was driven largely by the expansion in the central Reserve Bank's net foreign assets."

The net foreign assets of the banking sector, on incremental basis, contributed little less than 40 per cent of the money supply. In terms of reserve money, the contribution of net foreign assets of the RBI was still higher than the growth of reserve money during 2005-06 and 2006-07.

Over the long term, right from 1994-95, the net foreign assets of the banking sector have been a significant contributor to money supply.

So far, the RBI has been neutralising the impact of growth in foreign exchange reserves by using the mechanism of the Market Stabilisation Scheme, which sometimes leads to high or low liquidity. To save itself the problem of stabilising the forex market at a cost, the RBI can use the Capital Outflow Mechanism.

If the capital outflow can be augmented, the problem of excess liquidity will be automatically solved. However, as the opportunity of capital outflow would be determined by the domestic economic agents, the growth in foreign exchange may not be neutralised when desired.

Moreover, the forex reserves should be used to import essential investment goods to improve productivity as well as the production scale of the economy, particularly focusing on export units.

Dollar securities

The RBI should have some monetary instrument to neutralise the expansionary impact of foreign inflows without adding to the liquidity.

It can think of dollar bonds or dollar securities, which can be issued by the RBI and purchased by the authorised dealers by offering the foreign exchange accumulated with them. On maturity, the RBI will have to repay the dollar bond in dollars and the interest in rupees. The instrument can be used when there is a heavy inflow of foreign funds.

Another alternative would be to have 100 per cent capital account convertibility and free float, with no RBI intervention.

Thus, the exchange rate would be largely determined by the demand for and supply of foreign currency and movement in interest rates, inflation and real external and domestic economic fundamentals.

But in such a free market, linked to the global market, the central bank will have to be more stringent and sophisticated in operating monetary policy.

At the government level, efforts will have to be made to make the economy highly efficient across the board, particularly the public sector that is generally blamed for inefficient expenditure and wastage of financial resources, leading to a high-cost economy.

A free floating exchange rate would demand painful adjustments by the economy. This implies that our economic system should have the capacity to absorb a number of shocks and yet retain the momentum.

(The author is a former Economic Advisor to SEBI.)