The Hindu Business Line : Managing external shocks

The US Fed rate cuts have led to higher inflow of portfolio investments into the country resulting in inflationary pressures and rupee appreciation. Increasing the supply of goods and services in the domestic market seems to be the only way to maintain equilibrium amidst the volatility.

M. Y. Khan

Fluctuations in foreign exchange reserves of the countrysince April 2005 were caused mainly by the boom in the inflow of foreign portfolio investment, foreign direct investment and monetary liquidity.

The forex reserves have grown from $142 billion in April 2005 to $229 billion in August 2007, despite the high trade deficit and current account gap. The pile up of foreign exchange reserves can be treated as external liabilities which earn low yield as they are invested in foreign government securities.

Though the low yield is a cause of concern, one must not forget that in 1990-91 the foreign exchange reserves were not enough to meet the payment even for one week’s import. India’s international credit worthiness was at peril then. This is the reason for the Government observing caution in adopting full current account convertibility and in accelerating capital outflow. This is despite the rupee appreciating by more than 12 per cent vis-a-vis the dollar over the year and monetary policy being under pressure to maintain an equilibrium between the appreciating rupee and inflation.

Rupee appreciation

This equilibrium is difficult to achieve. A question in the minds of policymakers is that is there a better alternative to using the Market Stabilisation Scheme to check the rupee appreciation, which has been depressing export growth.

One solution could be building export capability to have current account surplus and augment forex reserves instead of inviting foreign capital through the capital market resulting in rupee appreciation.

Trade situation

Let us analyse the trade position of the country. We have been incurring large trade deficit as our exports fell short of imports by $52 billion in 2005-06 and $65 billion in 2006-07. Even after adjusting for surpluses on invisible transactions, current account deficit was as high as $9.1 billion in 2005-06 and $10 billion in 2006-07.

It may be around $10 billion in 2007-08. Thus, the level of trade deficit should have been enough to depreciate the rupee and augment export growth. But it did not happen due to the appreciation of rupee. If the productivity and efficiency of exports were higher than the rupee appreciation and some fiscal incentives at the stage of production of goods were available, the impact of rupee appreciation on exports would have been marginal.

However, India has to intensify efforts to diversify the export basket and focus on less exploited markets of Africa and South America, East Europe, Central Asia and Australia and New Zealand.

Forex management

Another area of concern is the management of forex reserves. The first step in this direction is to slow down portfolio investment, which has been causing high volatility in the stock market and prices of other assets. However, one should tread with caution as the high prices of financial assets and real estate can be reversed by sudden change in business cycle due to global pressures. If this happens, there can be turbulence in the financial markets, which is likely to hurt the real economy.

Hence, it should be our priority to keep prices of financial assets stable and liquid. We should cap the prices of assets such as equity if they cross the real fundamentals of a company, and real estate prices should not be allowed to increase at a rate higher than the GDP growth. There should be a regulatory authority to checkreal-estate transactions and manipulation in this sector.

Globalisation of financial markets has caused a lot of instability. Changes in interest rates in the US by the Federal Reserve have impactedfinancial stability by inducing booms and depressions and pressurising the domestic central banks to move interest rates in consonance with the changes in the Fed rates.

Central banks of other countries too have been busy adjusting the domestic monetary policy to external factors. For instance, if the Fed cuts interest rates, funds will tend to move out of the US to other markets such as India, pushing inflation and exchange rates upward.

The central bank naturally comes under the pressure of increased liquidity which needs to be countered by issuing repos. Fed rate cuts have increased foreign portfolio investment flows into India resulting in greater liquidity tightening by the RBI through market stabilisation scheme.

Interest rates, money supply, exchange rate and inflation rate are variables which often do not move in the same direction, and it is difficult to achieve an equilibrium even in the short term. Hence, the real economy has to adjust to mitigate the impact of instability and volatility in financial markets and, more important, goods market. The solution, therefore, lies in increasing the supply of goods and services in the Indian domestic markets to match the demand at efficient cost which can absorb the shocks of appreciation of the rupee, inflation rate and competitive pressures from foreign markets.

If our real economy is efficient, it can support the financial sector and provide a cushion to the central bank’s monetary policy. This cannot be achieved unless Government funds are directed towards building infrastructure in power, transport and other energy sectors. If food production had been planned keeping demand in mind, there would be no need to import foods items, which has resulted in greatertrade deficit.

(The author is Chairman, Inter-connected Stock Exchange of India Ltd., Navi Mumbai)

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