THE OTHER SIDE
A V RAJWADE
The recent appreciation of the rupee, from ~68 per dollar at the end of January to less than ~65 earlier this week, even as the wholesale price index is at a 39-month high at 6.55%, reminded me of what happened less than four years ago. In late July 2013, the exchange rate was ruling below ~61 per dollar; it fell to over ~68 per dollar in early September. In other words, at that time, the rupee fell almost 12 per cent in five weeks. To be sure, the recent rise has been less in percentage terms but the root cause of the sharp changes then and now has been the same — portfolio capital flows, ostensibly triggered by changes in US monetary policy.
Interestingly, monetary policy changes were in the same direction, but had exactly the opposite effect on portfolio flows! In 2013, the announcement by the US Federal Reserve that it would reduce money supply growth led to what media termed as the “taper tantrum” and outflow of portfolio capital from India (and, indeed, other emerging economies) and a sharp fall of the rupee. Recently, the hike in USD interest rates has led to exactly the reverse effect, with a sharp rise in portfolio capital inflows (a record $6 billion in March so far), and an appreciation of the rupee (I am sure pundits will find “retrospective rationalism” in both!).
To my mind, this incident once again illustrates the weakness of the exchange rate policy followed by the Reserve Bank of India for the last eight to nine years — intervening in the market only to curb volatility, allowing the level to be determined by demand and supply in the market. The only theoretical justification for such a policy is the belief that markets are “efficient”, that market prices of assets — equities or currencies or even commodities, which has become an asset class — reflect all fundamentals; the theory also leads to the corollary that markets allocate capital where it is needed the most and therefore fetches the highest return. Even Alan Greenspan, an acolyte of Ayn Rand, the market fundamentalist, was forced to admit after the 2008 crisis that his beliefs in markets have been shattered by what had happened — some of our governors, however, still seem to have great faith in the markets.
What I have always wondered is why they do not leave the other price of money, namely its domestic purchasing power, also to markets, but intervene in markets by interest rate changes or open market operations to meet inflation targets. After all, in a globalised economy, with imports and exports forming 50 per cent of economic activity (besides tradeables whose prices are determined by import parity), surely both prices of the domestic currency are equally important for the health of the economy? There would be little risk in allowing the exchange rate to be market-determined if the principal sources of demand and supply were to be imports and exports. But in today’s world, where capital flows seem to have a much larger impact on the exchange rate, at least in the short to medium term, is it prudent to keep the exchange rate at the mercy of fickle portfolio investors? This apart, the recent appreciation may well lead to further portfolio capital inflows, in a feedback loop.
There are macroeconomic risks in both directions. An overvalued currency would add to the problem of non-performing assets of the Indian banking industry since it would worsen the prospects of the tradeables sectors further. Even the International Monetary Fund, in its recent Article IV assessment of India’s economy, has argued that “real appreciation of the Indian rupee (was one of ) the key drivers of the export slowdown”. And a sharp, sudden fall would create problems for companies with unhedged external loans, an issue about which the central bank has often expressed concern. It forgets that:
Its own exchange rate policy has not depreciated the rupee to the extent of inflation differentials, which broadly parallel interest differentials. Over the last eight years, the rupee has depreciated against the dollar at about three per cent per annum, much less than the interest differential. It is not therefore attractive for the corporate sector to hedge external loans.
Again, if the corporate sector does want to hedge long-term exposures, where will the supply come from when the gap between assets and liabilities at the macro level is as high as $350 billion plus? In other words, who will take the other side of the swap?