Exchange rates, jobs & external vulnerability

Before our political masters talk of a sovereign wealth fund, we need a far better balance between external assets and liabilities

Recently, The Observer newspaper of UK criticised President Donald Trump for his “petulant, childish behaviour combined with a staggering lack of knowledge and contempt for facts”. While I agree with most epithets, on one point Trump is surely right: that the huge and persistent trade deficit of the US has led to much lower employment in the domestic industrial sector than what it otherwise would have been. He blames China, Mexico and everybody else for the deficit, but not the vaunted “strong dollar” policy of the US, which keeps up the consumption level of the worse off through cheap imports.

Recently, there seems to have been a policy change: the Treasury Secretary said last week in Davos that he welcomes the dollar’s recent fall in international markets, as it will help domestic industry. But the US deficit does not lead to external vulnerability or a balance of payments crisis as the dollar remains the world’s principal reserve currency: in effect, the rest of the world’s central banks finance the deficit by buying and holding US government securities in their reserves.

One sometimes wonders whether we are following a “strong rupee” policy to help meet the inflation target, which I described in the last article as possibly a major policy blunder of the present government. The exchange rate against the dollar has appreciated from a low of ~68 to ~64 in two years despite our inflation being higher than most of our trading partners, and when the oil price is rising. The central bank’s REER index stands at 132, evidencing 30 per cent overvaluation. Apart from the loss of output and jobs which persistent external deficits represent, does this policy make our external situation vulnerable to capital flight?

Remember Mexico, Thailand, Argentina etc? Recently even surplus countries like China, South Korea and Taiwan, have expressed worries over the rise of their respective currencies against the dollar. This apart, labour intensive exports, like garments and leather goods, require a competitive exchange rate even more than technology intensive exports.

In order to understand the central bank’s policy perspectives better, I recently went through the PPTs of a presentation by Dr Viral Acharya, in New York last month on the topic of “Global Spillovers: Managing capital flows and forex reserves”. Two points struck me:

— To measure “resilience” to foreigners running away (that is, capital flight), he correctly refers to the need to consider all reversible “hot money” flows;

— But in his measure of “external sector resilience”, meant to answer the question “if foreigners run, does the country have adequate FX reserves?” he seems to consider only short-term external debt. His measure is (reserves – short term debt)/GDP. I have not understood the rationale for dividing by GDP: If a divisor is needed, surely total trade is more relevant?

In my view, we need to look at FPI (in both debt and equity markets) also to measure our “external resilience”. And as of September 9, 2017, the potential outflows were $348 bn, including short term debt of $94 bn, as compared to reserves of $400 bn — and our IIP was a negative $400 bn as on that date. Are these numbers not enough to measure our external resilience to capital flight?

I could also not follow what exactly he means by “retrenchment state” — is he referring to capital flight and a currency crisis? To be sure I did not follow many other points in the presentation. To quote a couple:

“firms have two markets to undo the central bank reserves”;

“If tax on foreign currency debt is high, then firms switch to domestic currency debt in spite of higher cost. Hence, central bank has to tax both margins of arbitrage”.

Perhaps the presentation was meant for a far more sophisticated audience of US students, not ignorant Indians!

In my view, our most serious weakness is the exchange rate policy being followed for the past decade. The best way of ensuring resilience to capital flight is an exchange rate policy aimed at a balanced primary income and expenditure account (i.e. excluding secondary income like remittances). Before our political masters talk of a sovereign wealth fund, we need a far better balance between external assets and liabilities, that is, IIP. And, this will not be possible if we give priority to money as a store for value, which benefits the better off, over money as a means of exchange.