The price of not stocking forex

Looking back, the one cardinal error committed during Duvvuri Subbarao’s tenure as Reserve Bank of India (RBI) Governor has been not to sufficiently stock up the country’s foreign exchange reserves when the situation permitted it.

This is unlike previous Governors, especially Y.V. Reddy and Bimal Jalan, who utilised every available opportunity to add to the reserves, which could serve as insurance against speculative attacks mounted on the rupee.

The absence of such a war-chest has never been felt as much as now, when all that the Government and the RBI can do is to watch from the sidelines as the rupee is being subjected to an unprecedented bear attack.

Of course, all this we can say only now – with the benefit of hindsight.

Then and Now

The economic scenario was tumultuous when Governor Subbarao assumed office in September 2008. Five years down the line when he is about to relinquish office, the economic scenario is tumultuous once again.

But five years back, the turbulent financial conditions were purely on account of the collapse of the Lehman Brothers. This culminated in the global financial crisis and adversely affected the Indian economy through the trade, capital and the confidence channel.

The present economic malaise, by contrast, has more to do with homegrown problems both in the monetary and fiscal space.

The current macroeconomic scenario is characterised by low growth, high consumer inflation, depressed equity markets, deterioration in the external sector and pressure on government finances.

External Sector decline

External sector indicators --- reflected through current account deficit as a proportion of GDP, the external value of the rupee, forex cover for imports and forex cover as proportion of external debt -- have all deteriorated during Subbarao’s regime.

For instance, the current account deficit increased from 2.8 per cent in 2009-09 to 4.8 per cent in 2012-13, the forex cover for imports decreased from 9.4 months to 6.3 months and external debt as proportion of forex increased from 88 per cent to more than 130 per cent. The rupee-dollar exchange rate has depreciated from a calendar year average of 43.5 in 2008 to around 65 now.

Importance of Forex

The deterioration in the external sector is partly attributed to the change in policy stance towards exchange rate management under the stewardship of Subbarao. RBI adopted a stance of virtual non-intervention in the forex market during his tenure.

It is not that previous Governors had adopted a highly interventionist approach to exchange rate; they, however, utilised opportunities to build the forex reserve.

Y.V. Reddy, Subbarao’s predecessor, appreciated the fact that building up forex reserves is as important a plank of exchange rate policy as reducing excessive volatility in exchange rates.

In fact, he believed that adequate forex reserves can act as an insurance against possible attacks on the currency by speculators.

During 2003-04 and 2004-05, when capital flows were robust, the RBI purchased dollars to build forex reserves, which instilled confidence and might have been one of the reasons for investor interest in the Indian economy in subsequent years till the outbreak of the Lehman crisis.

Missed Opportunity

The significant increase in forex reserves in view of the steady inflow of foreign capital in the high growth years of 2003-04 to 2007-08, had even led to suggestions to create a sovereign wealth fund and use forex to finance infrastructure.

Going by the comfortable levels of forex reserves when he assumed office, Subbarao perhaps felt it was always going to be a problem of plenty, as far as forex reserves were concerned. The belief at that time that Indian economy was decoupled from the rest of the world might have also contributed to a sense of complacency towards building up adequate forex reserves.

The erosion in forex assets by almost US $55bn in 2008-09 should have acted as a warning bell.

This complacency towards building forex reserves becomes all the more apparent when capital flows were robust; following the quantitative easing by Fed, there was no conscious attempt to purchase dollars by the RBI and build the forex kitty.

Instead, the rupee was allowed to appreciate. The Real Effective Exchange Rate (REER) indices for six-currency, 30-currency and 36 currency baskets exhibited appreciation of the rupee during 2010-11. The economy perhaps would have been better off, had RBI intervened.

Intervention in the currency markets by buying foreign currency and selling rupees when capital inflows were robust, rather than a hands-off approach, would have been more rewarding. This would have prevented the rupee from becoming overvalued and augmented foreignexchange reserves.

As inflation was a major cause of worry during 2010 and 2011,it was possibly felt that forex market intervention would have added to liquidity by making inflation management more difficult.

But the liquidity impact of the forex purchase by RBI could have been sterilised by an arrangement similar to MSS scheme introduced when capital flows were robust during 2004-05.

In hindsight, it was a mistake to have ignored the importance of reserves as insurance for the stability of the forex markets.

A hands-off approach to exchange rate management, pursued without any reference to the adequacy of forex reserves, has resulted in RBI having no choice but to play to hands of speculators in tuning its policy.

If there is any lesson to be drawn from the current mayhem in the forex market, it is that forex reserves should have been built up during the last round of capital flows in 2010 and 2011.

Subbarao believed in the market mechanism of demand and supply to determine the true value of the rupee in the forex market. It is now well established that markets left to themselves do not function efficiently.

For markets to function effectively, institutions and players not only need guidance and hand-holding of the regulator, but also the fear of being punished for wrongdoing. With, say, another $200 billion in its kitty from forex market intervention, RBI’s response to speculators would have been more credible.

The author is Professor in Economics and Acting Dean, Xavier Institute of Management, Bhubaneswar.

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