The Hindu Business Line : Dr Jalan on exchange rate, reserves

The RBI Governor, Dr Bimal Jalan, said in a recent lecture that the global consensus view is now clearly in favour of a float or flexible rates, but noted that a completely free float without intervention is clearly ruled out.

EXCHANGE rates have always excited controversy. Indeed, one of the most politically explosive economic episodes in India's history concerned the devaluation of the rupee in 1966. The ruling party was sharply divided, with the anti-devaluationists led by the former Finance Minister, T. T. Krishnamachari, supported by political heavyweights, like K. Kamaraj.

The issue became divisive, in spite of Indira Gandhi's attempt to consult leaders of different persuasions in the country within the ruling party, besides leading economists. Controversy raged and devaluation was condemned.

While the allegation was that devaluation was forced down our throats by the usual suspects — the US Government and the Bretton Woods twins — the fact remains that the economic developments, including a deteriorating balance of trade, made the change almost inevitable.

Notwithstanding the differences that the decision involved, it turned out to have been economically right, although politically divisive. The developments of the succeeding decades showed that India's economy gained by the devaluation, albeit after passing through some difficult times.

We are today at a different phase of history. Economists and politicians — such of those who care — are debating the opposite question whether India has allowed its currency to appreciate too much. Is the rupee too costly in terms of external currencies? Are we following the right exchange rate policies?

Surely, no accusing finger is pointed at the Bretton Woods twins or the US. The criticism is directed at the central bank's management of reserves and intervention in the market. Some critics feel the RBI has allowed the rupee to go too high. Some feel that the rupee should be allowed to find its own level.

Dr Bimal Jalan has tried to set the controversy at rest by analysing the various options before the country. In a characteristically lucid exposition of the issues, he outlined the problem and its solutions in his lecture on "Exchange Rate Management — An Emerging Consensus" before the Forex Association of India on August 14, 2003.

The thoughts of the Governor are well worth discussion before a larger forum. Hence, this piece.

Dr Jalan surveyed, with the clear touch of a master, the current global debate on the best practices for forex reserves and exchange rate management. He noted that while consensus in the strict sense of the term has not yet emerged, there is a fair degree of convergence in the dominant international opinion among the experts and various specialised institutions on many of the issues.

There is a "dominant" view that is commanding international acceptance, according to which perception, a fixed exchange rate, even with a Currency Board, is clearly out of favour. Dr Jalan said that there has been a pronounced shift in global thinking on this subject. The global consensus view is now clearly in favour of a float or flexible rates. These are considered the only sustainable ways of having a less crisis-prone exchange rate regime.

Dr Jalan noted that opinions differ on the degree of flexibility in regard to exchange rate. A completely free float without intervention is clearly ruled out. Dr Jalan noted that the exception to this rule is a few global or reserve currencies. But, even in respect of these currencies, intervention is often practised.

The history of global currencies after the breakdown of Bretton Woods is clearly indicative of the number of occasions on which developed countries, such as the US and Japan, tried to intervene to settle the exchange rate of their currencies. A perfectly free float without intervention is not feasible in the real world, with the impact that exchange rates have on competitiveness of countries.

Richer countries also try to manage their currencies by forcing other countries to revalue, as happened in the case of the US versus Japan. Now, the US is trying to do the same with China. Forcing China to revalue is equivalent to the US devaluing, but without saying so.

What is important to note is that countries, by and large, have come round to accepting floating as a preferred practice — but mostly managed floats.

Dr Jalan noted that there has been a significant change in the pattern of global capital flows, which makes this transition to managed floating necessary. Capital flows have tended to become the primary determinant of exchange rate movements, in place of trade flows.

Further, gross flows in gross terms are several times higher than net forex flows. This means that the phenomenon known as "herding" has become unavoidable. All dealers prefer to be wrong with everyone else than being in the wrong alone.

One question that Dr Jalan raised and answered is about the adequacy of exchange reserves in a regime of floating exchange rates. It can be theoretically argued, he said, that in a regime of free float, exchange rates would be determined by demand and supply and there is really no need for reserves.

But the need for reserves arises because of the factor of volatility. He noted that in the light of the volatility induced by capital flows and the self-fulfilling expectations that they can generate, emerging market countries should, as a matter of policy, maintain adequate reserves.

Dr Jalan said that from the earlier simplistic measure of so many months' of imports, adequacy criteria have changed to include the need to cover likely variations in capital flows and the liquidity risks. There is as yet no consensus on the upper limit of reserves.

He stressed the obvious point — true in India — that even after an adequate level is reached, reserves may continue to increase, if flows are strong and central banks decide to intervene in order to moderate the degree of appreciation.

Dr Jalan discussed the various alternatives posed by experts regarding India's forex policies. He noted that, by and large, the exchange rate management policy of India has received approbation from international observers. India's policies have been described by the IMF, he said, as being comparable to the global best practices.

He also cited the vote of confidence given by a global news agency, which has recently described India's currency model as the best for Asia. Dr Jalan said India is one of the few developing countries that has set up its own clearing house for dollar-rupee transactions with the concurrence of the US Federal Reserve system.

Dr Jalan noted that Kenneth Rogoff of the IMF had expressed the view that the rupee should be allowed to appreciate freely in line with the market trend. According to this view, there is no need for the RBI's further intervention as reserves are already high.

Dr Rogoff's view is that unconstrained appreciation would not affect growth prospects. But this view is contested widely, especially by industry associations, which plead for intervention to mitigate the extent of appreciation. This is particularly so since India's competitiveness is to be reckoned with reference to competitors, like China, whose currency is pegged to the dollar and is therefore depreciating with the dollar.

While discussing the alternative approaches, Dr Jalan made it as clear as a central banker can that there is no definitive answer. He does not seem to favour the alternative which abandons the current practice of managed float and the RBI's intervention. He is definitely against the alternative of keeping the rates fixed at current levels.

Such options did not work well in East Asia. A fixed exchange rate system is ruled out, even though China seems to be a votary of the same, thanks to its special characteristics — high trade surpluses and high FDI flows.

Dr Jalan, however, noted that the competitiveness of the exchange rate has to be decided not only in respect of a single currency, like the dollar, but with reference to multiple currencies. In his lecture, Dr Jalan clearly ruled out immediate steps to further liberalise the capital account. In his judgment, we have gone as far as is justified.

Allowing residents to convert their domestic assets to foreign assets — one extreme version of capital account convertibility — would be impractical considering that if fearing a devaluation a large number of residents decide to do so simultaneously and within a short period of time, the expectation would become self-fulfilling.

The domestic stock of bank deposits in rupees in India is close to $290 billion — three and a half times our reserves. Surely, a quick shift to full capital account convertibility is not in order.

All in all, Dr Jalan came out with a clear and considered view on what our exchange rate management policy and reserve levels should be. He expects that further debate will enable a clearer enunciation of options and their exigencies.

But, as matters stand, we have been told that while the present system is by no means an ideal one, all the alternatives are worse. "Solutions, which seem "ex ante" optional, may turn out to be disastrous experiments — after the event".

Perhaps, we have to let the debate rest on this note until events change our view of alternatives or force other options on us.

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