Right policy mix for the rupee

The major international currencies are in turbulent waters and many currencies are facing volatility with downward swings. As per the analytical construct of the Impossible Trinity, it is not possible to have a fully open capital account, an independent monetary policy and a managed exchange rate; one of these objectives has to be jettisoned. In India there are still a number of capital controls and monetary policy is not fully independent. As such, it is reasonable to have some hold over the exchange rate.

Given the fragile financial structure it is hazardous to totally give up one of these objectives and it should be possible to optimise policies following the general theory of the second best.

EFFECTS OF CAPITAL FLOWS

In the 1990s, the Reserve Bank of India (RBI) considered the real effective exchange rate (REER), based on the five-country model, as a ‘policy polestar'. As capital inflows gathered momentum there were fears that a marauder could “break the Bank”. While after 1997, the RBI continued to be guided by the REER, there was a move from the explicit REER basis to an implicit REER policy.

As capital inflows increased, there was a growing concern that in the absence of forex intervention, the current account deficit (CAD) could rise substantially above the level of 3 per cent of GDP. Between 2003 and 2008, there was decisive action to avoid excessive appreciation through aggressive forex intervention combined with sterilisation of the increased domestic liquidity.

In the more recent period it would appear that the RBI has been reluctant to intervene if the rupee appreciates but is willing to take action if it depreciates.

The recent movements in the exchange rate are revealing. The REER six-country index (with 2004-05=100) rose from 98.48 in September 2009 to 119.16 by July 2011 and then depreciated to 113.87 by August 2011 (there has been further depreciation in September 2011). The RBI last undertook purchases in November 2010. It was only in September 2011 that the RBI undertook sales to stem the depreciation of the rupee.

If the exchange rate policy is strictly non-interventionist, a la New Zealand, then there would be no need to hold any forex reserves. A policy of not intervening when the rupee appreciates has a corollary that there should be no intervention when the rupee depreciates. An asymmetrical policy of intervening only when there is depreciation is obviously unsustainable.

Although capital inflows are much higher than the CAD, they are capricious and, as such, it is best to keep the CAD within 3 per cent of GDP. If the surplus capital flows are mopped up through forex intervention there would an increase in domestic liquidity. If the surplus capital flows are not mopped up by forex intervention, domestic liquidity would swell or the CAD would widen. It would be preferable to bolster the forex reserves and then deal with excessive domestic liquidity rather than try and contain the CAD by reducing domestic liquidity.

A purist policy of non-intervention in the forex market would require that there are effective monetary policy instruments to deal with the evolving liquidity situation. As it is, monetary policy is bartered away to handle the fiscal excesses. An increased burden on monetary policy would imply a quantum jump in interest rates and reserve requirements.

The time-tested policy of intervening in the forex market (both ways) would need to be blended with monetary policy tightening supported by Stabilisation Bonds. This provides for a more equitable burden-sharing among the overall policy instruments.

APPROPRIATE EXCHANGE RATE

Given the interest rate differentials between India and the major industrial countries, the rupee should be at a discount in the forward market whereby the interest rate differentials are reflected in the forward exchange rate.

Forward market intervention can be more effective than spot intervention. The net forward purchases/sales have been zero since November 2011 and the RBI could significantly reduce domestic liquidity pressures through aggressive forward intervention.

Whichever way one looks at it, the authorities need to have a fix of some sort on what they consider an equilibrium exchange rate.

Considering the nominal exchange rate, the secular depreciation since 1993 has been of the order of 1.5 per cent per annum which is insufficient to cover the inflation rate differentials and the interest rate differentials. Hence, there is a need for the nominal exchange rate to depreciate.

An iconoclastic approach of abjuring the REER as a reference point, without a new creed in place, could be dangerous. The present exchange rate policy articulation emphasising “volatility” leaves market players without a reference point and creates confusion in the forex market. A dedicated, clear enunciation by the RBI top management of the present exchange rate policy is the need of the hour.

(The author is an economist. >blfeedback@thehindu.co.in )

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