Cur­rency man­age­ment needs an over­haul

The macro im­bal­ance is a re­sult of al­low­ing ex­ces­sive cap­i­tal flows. As a re­sult, the ex­change rate has ceased to be com­pet­i­tive

The Hindu Business Line - - THINK - V KU­MARASWAMY

The cho­rus for reduction of real in­ter­est rates as the panacea for the cur­rent eco­nomic slow­down is get­ting louder. From com­men­ta­tors to ad­min­is­tra­tors to economists, that seems the only item on the menu these days.

In­ter­est rates (nom­i­nal and real), inflation, forex rates and re­serves, in­vest­ments, cap­i­tal ac­count con­vert­ibil­ity and for­eign in­vest­ment flows (all from the in­put or causative side) and growth, out­put and em­ploy­ment on the re­sul­tant side are in­tri­cately in­ter­con­nected. There seems a need to look at things com­pre­hen­sively and evolve a frame­work agree­ment be­tween the RBI and the gov­ern­ment.

Peo­ple buy things in ad­vance if ei­ther it is likely to be costlier in the fu­ture when they need it or for de-risk­ing (like gold and real es­tate). But what if the re­alised prices later con­sis­tently prove to be lower? Would peo­ple still buy upfront or would it in­di­cate some dis­crep­ancy? Let us see it in the con­text of forex rates.

The ac­tual rates post facto have con­sis­tently been lower (far lower) than the for­ward rates (rates quoted to­day for dol­lar that will be de­liv­ered say three, six months later).

The first one is de­ter­mined based on the dif­fer­ence in inflation rates over the pe­riod con­cerned, and the sec­ond one based on dif­fer­ence in nom­i­nal in­ter­est rates. If the real in­ter­est rates are de­ducted from nom­i­nal, then the move­ment in both should be de­ter­mined by dif­fer­ence in inflation, pro­vided there are no ex­cess cap­i­tal flows vis-a-vis the CAD.

The per­sis­tence of ac­tual rate be­ing way less than for­ward rate rep­re­sents

a se­ri­ous im­bal­ance and causes prob­lems in do­mes­tic com­pet­i­tive­ness, flow of for­eign cur­rency, in­vest­ment ab­sorp­tive ca­pac­ity, etc. For ex­am­ple, if apples (rep­re­sen­ta­tive of a bas­ket of goods) are sell­ing at Rs 50 in In­dia and $1 over­seas, then ex­change rate should be ideally 1$ = Rs 50. Say, next year In­dian apples have suf­fered an inflation of 10 per cent and have gone up to Rs 55. But apples over­seas have suf­fered an inflation of 2 per cent and gone up to $1.02. Then the ex­change rate should be Rs 55/1.02 = 53.93. But if the ex­change rate is kept at say Rs 51, then the In­dian ex­porter will get 1.02$ X 51 = 52.02 Rs /ap­ple while he is able to get Rs 55 sell­ing it do­mes­ti­cally. Why would he ex­port? To over­come this, we should al­low the Re to cor­rect. This will hap­pen if we match the $ sup­plies into In­dia with its net ex­ports.

Con­tours of a new frame­work

Given this im­bal­ance, the frame­work pact be­tween the gov­ern­ment and the RBI should cover all es­sen­tial vari­ables, not just one or two in iso­la­tion. Such an agree­ment should cover the fol­low­ing.

Limits on forex in­flows: The in­flows should be cal­i­brated to match the ab­sorp­tive ca­pac­ity of the econ­omy and its in­vest­ment needs. While cap­i­tal ac­count con­vert­ibil­ity can re­main, RBI has to limit the quan­tum ei­ther at to­tal lev­els or un­der each ma­jor source of in­flow. Re­serves are a costly loss-mak­ing in­sur­ance as­set (much like gold with in­di­vid­u­als) whose costs are far more than the dif­fer­ence be­tween in­ter­est earned and paid. IThe limits can be +/- 1-2 per cent of what is re­quired to plug the CAD or 6 months’ im­ports +/- 2 weeks.

Main­te­nance of com­pet­i­tive­ness: Com­pet­i­tive­ness com­prises two el­e­ments — the phys­i­cal and the cur­rency. Phys­i­cal com­pet­i­tive­ness comes from tech­nol­ogy, scale, skills, IPRs, and nat­u­ral re­source en­dow­ments over which nei­ther the RBI nor the gov­ern­ment may have con­trol. Cur­rency, dis­torted by cap­i­tal flows, needs to stay com­pet­i­tive which can be achieved only if it floats freely to re­flect the inflation dif­fer­en­tial.

Forex rates: RBI should be man­dated to main­tain the REER val­ues (now the ex­change rate is far lower than the REER value). The present mas­sive di­ver­gence can be set­tled now on a one-time ba­sis, with no more than 2-3 per cent de­vi­a­tion be­ing per­mit­ted sub­se­quently.

Re­cal­i­brat­ing REER val­ues: Again, in­stead of us­ing the gen­eral inflation num­bers of the coun­tries to ar­rive at an REER band, it should be the inflation of ma­jor in­put costs (in­clud­ing in­ter­est costs) of goods and ser­vices traded be­tween In­dia and its ma­jor trad­ing part­ners.

There are real dan­gers of cur­ren­cies as a whole be­ing gov­erned by fac­tors other than what de­ter­mines com­pet­i­tive­ness.

Real in­ter­est rates: Real in­ter­est rates should be man­dated to be within 5-10 bps spread over in­ter­est rates in com­pet­ing coun­tries and those in­vest­ing into In­dia.

High real in­ter­est rates and over­val­ued cur­rency may en­cour­age debt flows more than in­vest­ments in real as­sets and FDIs.

Inflation: Di­ver­gence be­tween es­ti­mated ac­tu­als and re­alised ac­tu­als after the end of pe­riod is dif­fi­cult to con­trol even for items like forex rates.

It’s time we move on to inflation tar­gets for 3-4 ma­jor groups. Food inflation is more po­lit­i­cally sensitive and so­cially dam­ag­ing than white goods or real es­tate.

Sta­bil­ity of laws: The last 4-5 Forex re­serves be­yond a limit can be coun­ter­pro­duc­tive

years have seen sud­den sharp changes in rules gov­ern­ing pro­vi­sion­ing, NPAs, de­fault sta­tus, etc. and lev­els of sup­port to distressed as­sets even those which are clean but fac­ing stretched cash flows. Changes should fac­tor in rea­son­able ad­just­ment pe­riod.

Quid Pro Quo

If these are cor­rected, gov­ern­ments should un­der­take to do the fol­low­ing:

(i) To stay within the 3-4 per cent fis­cal deficit tar­gets,

(ii) To smoothen MSP in­creases based on fun­da­men­tals rather than sub­ject to po­lit­i­cal whims and fan­cies,

(iii) To cur­tail in­ter­est de­clared on man­dated sav­ings like PF, PPF etc.,and

(iv) Not to an­nounce ar­bi­trary min­i­mum wages.

The cur­rent eco­nomic im­passe is aris­ing out of highly over­val­ued cur­rency, un­com­pet­i­tive real in­ter­est rates and in­flows far in ex­cess of ab­sorp­tive ca­pac­ity. The en­tire bur­den of spurring growth and em­ploy­ment hence falls on the gov­ern­ment which has to substitute

for the pri­vate sec­tor, ren­dered un­com­pet­i­tive due to these im­bal­ances.

An agree­ment on the above lines would go a long way in kick start­ing growth and em­ploy­ment.

The noted econ­o­mist Irv­ing Fisher in his book The Money Il­lu­sion quotes Regi­nald McKenna, Chan­cel­lor of Ex­che­quer UK as fol­lows: “Since the War, cen­tral bank re­forms have been in­sti­tuted in Al­ba­nia, Aus­tria, Chile, Colombia, Ger­many, Hun­gary, …In­dia, Rus­sia, South Africa. In all these coun­tries, ex­cept In­dia, not one cen­tral bank has copied the Bank Act of Eng­land;... all have adopted some sys­tem which is sim­i­lar to the Fed­eral Re­serve Act” which pro­vides for an ‘elas­tic cur­rency’… the greater elas­tic­ity of the Fed­eral Re­serve Sys­tem (is) the main rea­son for the higher pros­per­ity of Amer­ica”.

What was true then of the US is true to­day of China which has proved far more nim­ble footed than In­dia.

The writer is the au­thor of Mak­ing Growth Hap­pen in In­dia


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