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A. Seshan

The Indian currency is near the Rs 48 level against the dollar. Sometime back, the Finance Minister announced that the Reserve Bank of India would do the needful to arrest the depreciating trend. Obviously the bank’s intervention in the market has been too feeble to restore the value to any targeted level, though it may deny that it has such a target. It claims that it intervenes in the market to curb volatility.

Its experts can easily find out whether volatility measured by, say, the coefficient of variation, has reduced whenever it intervened. Between end-March 2008 and September 19, 2008 the Bank’s foreign currency assets were reduced by about $16 billion. Leaving out other factors, it is obvious that a substantial portion of the decline was due to the intervention in the forex market to arrest the depreciation of the rupee.

What was the net result? The reference rate of the bank, as on September 19, 2008 was Rs 46.32 a dollar marking a steep depreciation from Rs 40.10 on March 28, 2008. The bank would do well to leave the rupee alone in the forex market.

It would be foolhardy to try to influence the external value of the rupee through intervention. It was the hard lesson learnt by Thailand a decade ago which ushered in the East Asian Crisis. RBI’s Foreign Currency Assets (FCA) amounted to $282.8 billion, as on September 19, 2008.

There is enough evidence to show that market intervention by way of purchase of forex to stop domestic currency appreciation, followed by sterilisation of excess money thus generated, has no effect on the exchange rate.

A symmetric factor operates on the sale of dollars to halt rupee depreciation when at the same time liquidity shortage is met through massive repo operations. The trend in the exchange rate is back in square one in either case.

The net result is a fall in reserves in the latter case. The central banks of the developed countries stopped intervening in the market long ago despite volatility in rates after realising its futility.

The Guidotti-Greenspan rule of the norm of reserves to meet the debt obligations falling within a year is not appropriate in the current context. The FII investment is in the nature of hot money and can be withdrawn at any time without let or hindrance. Already around $10 billion is reported to have left the country this year. What starts as a trickle may become a flood in an atmosphere of uncertainty. The RBI should conserve its FCA to meet such an eventuality and not fritter them away in useless market interventions.

What are the consequences of the depreciation? It is good for exports. Of course, imports become costlier. Fortunately, the decline in oil prices from the heady heights it reached a few weeks ago takes away some of the sting in the fall in rupee value.

Given the bad shape of the international economy, especially the position of the US and other Western countries, one may safely assume the demand for oil to decline leading to a fall in its price.

To the extent that competing imported goods become costlier it should be welcome to the domestic sector, both agricultural and industrial. As for the imported raw materials going into production, including that for the export sector, the proper course for the entrepreneurs in the country is to devise strategies to make their best use through technological improvement.

After the first oil crisis the Japanese R&D worked feverishly to find ways of lowering the use of energy in production.

As a result, inter alia, a tonne of steel required only a half of its earlier level of energy. It enabled that country to withstand the second oil shock in the early 1980s. Our industry has not responded to crises through technological advances. Instead it asks for help in the form of subsidy, tax relief, etc.

The cost of exports going up in cases where imported raw materials are important need not be a limitation. Despite the appreciation of the rupee in the recent past exports registered a double-digit growth year after year. The reason is simply that the Indian rupee is undervalued in terms of purchasing power.

That the rupee is undervalued in terms of dollar is also substantiated by the World Bank’s high ranking of India in the comity of nations in terms of Gross Domestic Product when valued at purchasing power.

So if the export price goes up, it is not going to make a dent in sales in foreign markets as the rupee would still be undervalued in terms of purchasing power.

The concept of Real Exchange Rate in its various formulations was relevant when current account was the predominant element in balance of payments and the Purchasing Power Parity Theory held the field. But today it is the capital account, which determines the exchange rate in the market.

Of the total turnover in the forex markets, whether in the world or in India, those backed by real transactions in goods and services constitute relatively a smaller proportion than the pure capital flows. According to the latest Annual Report of RBI, the ratio of inter-bank to merchant turnover was 2.4 during 2007-8.

A third effect of depreciation is on external debt. This aspect has been neglected in the literature on the subject both here and abroad.

When rupee depreciates there is an increase in the external debt burden in terms of the local currency. Ceteris paribus, because of depreciation, the physical volume of goods to be exported is higherthan before to earn the same amount of forex to service the debt.

The rise in the real debt burden, as against the nominal one in foreign currency, was pointed out for the first time in the Report of the Policy Group on External Debt Statistics of India prepared in 1992 by a two-man group of Y.V. Reddy, then Joint Secretary in the Ministry of Finance, and this writer, an Adviser in the Department of Economic Analysis and Policy of the RBI. The policy for external borrowing needs to take note of this point.

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