The needless battle

Indian Express, 19th August 2013

Rupee defence strategy has deepened the gathering gloom on the India growth story.

The defence of the rupee is going horribly wrong. It has damaged two sources of hope for a growth pick-up in India - monetary policy easing and India's commitment to economic reform. When Chairman Ben Bernanke of the Fed talked about tapering quantitative easing in the US, it was expected that there would be pressure on emerging market currencies. Countries with weaker economies, and with larger current account deficits were likely to see more currency volatility. Instead of talking about this source of pressure, which all emerging markets faced when the dollar started appreciating, the government decided to step in to defend the rupee.

Evidence from across the world shows that a currency defence often fails. Every government trying to stabilise a currency is, therefore, fully aware of the chances of failure. A careful cost-benefit analysis of its strategy is thus an important pre-condition to initiating a defence. Since the global currency turmoil started, the government has been rolling out measures such as currency market controls, import duties on gold and silver, bans on purchase of gold coins and tightening of capital controls to stabilise the rupee. These dirigiste solutions seem oblivious of their likely impact on market expectations. They are based on central planning notions of bans and restrictions being the solutions to the economy's problems.

First came restrictions on currency derivatives markets by Sebi and the RBI. These markets inform people of expectations about the currency. This information may be unpleasant. The government may disagree with it. But instead of listening to what the market was saying, the authorities chose to try to silence it. Restrictions reduced the extent to which people could hedge their currency risk. This was a bad move, especially since the rupee was expected to become more volatile. It made investors less willing to buy rupee assets. Trading volumes on domestic currency derivatives markets fell sharply and the cost of hedging increased. Instead of making rupee assets more attractive, these measures have made them less attractive. Further, the restrictions have undermined the market's confidence about the government's commitment to financial market liberalisation.

Next came the liquidity squeeze and an increase in short-term interest rates. The complicated strategy hoped to keep long-term interest rates low. This, too, failed. When the rate hike saw a transmission of higher rates to treasury bill rates, long-term bond yields and deposit rates, it became increasingly clear that sooner or later bank lending rates would go up. To prevent that, the RBI kept the repo and CRR rate unchanged. This left the market in complete confusion. Were interest rates going to rise or fall? Statements by the authorities that the tightening was temporary till the rupee stabilises provided little comfort. Could the currency stabilise before US monetary policy went back to normal? How long was "temporary"? In an environment in which a monetary easing was expected to help push up growth, this sudden tightening was a shock. Interest rates are still high. The measures have undermined confidence about monetary policy easing.

After the liquidity squeeze failed to restore rupee stability, came tariff hikes and restrictions on gold and silver imports and tightening of capital controls under FEMA. Restrictions have been imposed on capital outflows by firms and households. Already, firms were suffering from the difficulties of the policy environment. If some of them were going to stay healthy by investing abroad, that was made more cumbersome. Hardly any money was going out by individuals investing abroad. But putting a restriction on these trickles sent out a bad signal to an already nervous market. These measures did not inspire confidence that the government's focus was investment and growth. Worse, they suggested that India's economic reforms are not deep-seated and can be reversed for short-term ends.

With the opening up of trade and the capital account, the currency market has grown very large. Old solutions, like selling a few billion dollars from our reserves to prevent appreciation, no longer work. Out of the three corners of the impossible trinity, a country can choose only two. For the last two decades, India had chosen to move towards an open economy and a flexible exchange rate. In the face of the QE tapering, it means choosing between rupee stability and lowering interest rates. But the government did not like having to make the choice. It wanted both. The only way to control the currency in such a situation is to close the economy. When the size of the market has shrunk adequately, the RBI can intervene and prevent depreciation without much loss of reserves.

If the rupee remains volatile, the government has to choose to either roll out the next measure it has on its list, or to find an exit route. FEMA allows the RBI and government to shut off all cross-border transactions for sale and purchase of assets. The market believes that as long at the rupee defence strategy remains in place, the authorities might impose restrictions on various other capital flows. This expectation has caused further gloom.

We should not lose sight of the big picture of Indian economic policy. The story of the last 20 years is one of slow but steady economic reform resulting in 7 per cent trend GDP growth. The day we walk away from the promise of slow but steady reform, the expectation of future productivity growth is shattered. This adversely affects the credit rating of India, stock prices, investment in India by locals and by foreigners, and capital flight from India. The needless battle the government has picked on the rupee, and the measures it has taken, have reinforced the already growing despondence about economic reforms. It has raised new questions on the India growth story. The government must immediately undo all the steps that have reversed economic reforms of trade or finance or capital account liberalisation. Otherwise, we will suffer deeper damage to the prospect of high GDP growth.

India Inc hedges its bets

Financial Express, 16th August 2013

Indian companies have borrowed heavily abroad, attracted by low interest rates. It is feared that a depreciation of the rupee will hurt corporate balance sheets adversely and make the economic situation worse. Measurement of firm currency exposure shows that, fortunately, this is not the case. All large and medium sized Indian companies, who are usually the ones who borrow in dollars, expected rupee depreciation. Most of them have hedged their currency exposure. This is not surprising considering the large current account deficit, the slowing economy, higher inflation and the expected increase in US interest rates coupled with the last few years of RBI's policy of not intervening in the rupee-dollar market.

Some exporters have a natural currency hedge when they borrow, some companies chose not to borrow abroad, while still others hedged in the derivatives markets. This behaviour is perfectly rational. If a depreciation was expected, it made little sense for a company to take a dollar loan, even if it was cheaper, whose payment would become more difficult in a couple of years.

Table 1:

	Gain from Appreciation	Neutral	Gain from Depreciation
2002-2004	300	1539	17
2011-2013	0	1201	81

Source: Author's calculations

Table 2:

Firms borrowing abroad		(March 2012)
Total number of firms:		8382
Firms borrowing abroad:		843
Amount borrowed abroad:		USD 236.66 billion

Source: Prowess, CMIE.

The data for firms borrowing abroad is available in the CMIE prowess data base. We see that in March 2012, out of 8,382 companies, only 843 companies, or 10% of all Indian firms, borrowed abroad. The data suggests that today also the figure should be roughly the same. However, exposure may arise in many other ways as well. For example, if a firm imports raw materials, but cannot pass on the increase in costs, its profit margins would decline.

Figure 1: External commercial borrowings (per month)

Hence we measure unhedged currency exposure of Indian firms. This measure uses an analysis involving daily stock market and currency data and, therefore, can be estimated till end July 2013. It measures whether the company loses or gains in value when the rupee-dollar rate moves, or the average impact of a 1% currency depreciation on the stock price. If the firm has hedged, then the stock price does not gain or lose value when the currency moves. We measure exposure for 1,282 of the listed firms that have fairly adequate liquidity.

First, we look back at the 2002-04 period. Here, there was large-scale trading by RBI on the currency market aiming to prevent rupee appreciation. Most market participants expected the rupee to appreciate. At this time, it was advantageous for firms to set themselves up to profit from the expected future appreciation by invoicing in rupees, hedging export proceeds, leaving imports unhedged, borrowing in dollars, etc. Our analysis shows that there were 300 large firms who had positioned themselves to gain from appreciation. There were 1,539 firms who did not have a statistically significant exposure. There were only 17 firms who did not expect an appreciation and would be hurt by it.

If, in that situation, a sudden and unexpected depreciation had taken place, it would have generated a substantial adverse impact upon these 300 firms who were betting on appreciation.

Then we turn to the latest two years ending in July 2013. Our analysis shows that there are no firms who have set themselves up to gain from appreciation. There are 1,201 firms who have no statistically significant exposure. There are 81 firms which stand to gain from depreciation. These are firms who would have invoiced in dollars, left exports unhedged, hedged imports, and not borrowed in dollars. Most firms were hedged. There was not a single firm who was expecting a rupee appreciation and took positions accordingly. The unhedged exposure, though little, is on the other side.

There is, of course, nothing really surprising in this. Few observers of the Indian economy were expecting a strong or stable currency. When the exchange rate is managed, firms have an incentive to throw caution to the winds. As long as the firm does not have to pay the hedging costs itself, it is always cheaper to borrow in dollars. In the past when the rupee-dollar exchange rate was kept stable, firms left their currency exposure unhedged.

This has two implications. First, firms take on more currency risk under a managed exchange rate. In 2002-04, there were 317 firms who were betting on exchange rate fluctuations. The floating exchange rate, which has prevailed from March 23, 2007, onwards, has induced fear in firms and fewer firms are leaving their currency exposure unhedged.

The second important implication is that at present rupee depreciation does not have an adverse impact for big and medium sized Indian firms that constitute the dataset. There are 81 firms who will actually gain from a large rupee depreciation. There are no firms who stand to lose from a rupee depreciation.

However, there are a large number of firms with interest rate exposure. These are firms who have borrowed domestically and expected an easing of monetary policy. These firms are much large in number. In fact, almost every firm has some borrowing. This borrowing is largely unhedged as there are few ways to hedge it in Indian markets today.

Monetary policy in an open economy involves making a choice between ensuring low currency volatility or ensuring low interest rate volatility. In both 2002-04 and in the last two weeks RBI intervened to provide low currency volatility. In this choice between currency volatility and interest rate volatility, most firms today would have a preference for higher currency volatility rather than interest rate volatility.

Looking forward, these episodes have important policy implications. Countries have experienced acute distress when a large part of the corporate sector had a certain bet (for example, betting on rupee depreciation) and things suddenly went the other way. It is good for India if firms are hedged. It makes the economy more resilient.

Raghuram Rajan takes helm at difficult time

OMFIF, 7th August 2013

Failed rupee defence creates formidable challenge for new India governor

The new governor-designate of the Reserve Bank of India (RBI), Raghuram Rajan, faces a formidable set of challenges: falling Indian growth, rising financial market interest rates and doubts whether the authorities have the will and the instruments to defend the plunging rupee.

Rajan, currently the Finance Ministry's chief economic adviser and honorary economic advisor to Prime Minister Manmohan Singh, has an enviable reputation as a former chief economist at the International Monetary Fund and the man who predicted the 2007-08 financial crisis. His appointment to replace Duvvuri Subbarao in early September comes at a crucial time.

The US Fed's moves towards tapering off its quantitative easing (QE) bond purchases have led to problems for the currencies of many emerging market economies with large current account deficits, but nowhere has the fall-out been greater than India. Having earlier held up well in comparison to other currencies (such as Turkey, South Africa and Brazil), the rupee has come under heavy pressure in the last two months.

The Indian authorities have reacted to the sharp depreciation by implementing a host of measures including engineering higher bank interest rates through a liquidity squeeze on the banking system, and imposing regulations that reduce participation in currency derivatives markets. However, the RBI has pointedly left unchanged its official interest rates.

Measures to reduce anti-rupee speculation have been ineffective, with the currency falling below the Rs 60 per dollar level that the authorities sought in the past to defend.

There is considerable confusion in the market. Will the RBI defend the rupee with further tightening and capital controls? When will it reverse its measures? One of the most difficult issues that the new governor faces is that many observers believe that the RBI's rupee policy, its implications for the domestic market, and the exit strategy were not well thought out in the first place.

The failed defence of the rupee has exposed clear policy shortcomings including lack of transparency and interference in financial markets. All this will be very costly for India. The governor-designate has pointedly said he has 'no magic wand' to resolve these problems. Nevertheless, expectations on him to make the right decisions are very high.

Since the 2008 crisis, the Indian exchange rate policy has, in general, been to allow the rupee to depreciate. First, this was because the fall in the rupee mainly reflected the dollar's appreciation, so there was little India could do about it.

Second, the depreciation was useful as it could help correct the large current account deficit. It kept the real exchange rate from appreciating as India has a higher inflation rate (at about 8-10%, measured by consumer price inflation) than its main trading partners.

Third, the RBI holds about $280bn of foreign reserves. This comfortably covers six months of imports, but would be insufficient if the RBI started to sell, say, $8-10bn a day to defend the rupee.

Fourth, increasing the RBI's official benchmark lending rates was considered inappropriate as the Indian economy has been slowing down, investment sentiment is weak and - even though inflation is higher than the authorities would like - price rises are starting to abate given the sharp deceleration in demand.

Why did the RBI react so strongly this time? The rationale for the sudden sharp defence of the rupee at Rs60 remains a mystery. Unlike the Indian government, many Indian companies have a large external debt. Defending their balance sheets could have been the ostensible reason to defend the rupee. In reality, however, most of these corporates expected a rupee depreciation and were hedged beforehand. An alternative reason could have been the fear of further inflation. However, this cannot be a strong justification, as core inflation is now below the levels reached in the last five years when the RBI didn't react.

The RBI started easing monetary policy in the beginning of 2013, but last month saw a sudden change as the rupee was seen to be too volatile. The RBI's action to protect the rupee did not include raising the repo rate or the cash reserve ratio, which have been the main tools of monetary policy in the last decade. Its flurry of actions led to a sharp rise in the overnight call money rate, the Treasury bill rate and the 10-year government bond yield. Auctions of government bonds failed, as the RBI failed to meet investors' yield expectations.

The RBI's decision to leave the repo rate and the cash reserve ratio unchanged has been a bid to persuade the domestic market that liquidity tightening was only temporary. The financial markets viewed this as a signal that monetary tightening would soon be reversed. The rupee depreciated further and the RBI and state-owned banks are now reported to be selling dollars.

The lack of rupee recovery has resulted in a wedge between the onshore and the large offshore (non-deliverable forwards) market for the rupee, a very tight domestic liquidity situation, higher deposit rates by some private sector banks and a further loss of confidence in Indian policy-making.

Whose monetary policy?

Indian Express, 5th August 2013

It should be left to an independent central bank with a clear brief and instruments

Indian monetary policy law, like that of many advanced and most emerging economies, needs to define the objectives of monetary policy. The sudden shift away from inflation and growth to a defence of the rupee has caused a lot of confusion. In addition, the law needs to lay down the instruments of monetary policy. This could be the repo rate or any other chosen rate. Once this is done, the RBI needs to be made accountable and given independence in order to achieve these objectives.

Today, even if the government achieves Rs 60 to the US dollar, the cost of defending the rupee is too high. Beyond the tangle that the RBI is now in, these events point to the larger question of monetary policymaking in India. Decisionmaking on monetary policy in India will become increasingly difficult in the next two years. The US Fed will stop easing and US interest rates will rise. If the RBI leaves interest rates in India unchanged, Indian assets will become relatively unattractive. This will put pressure on the rupee to depreciate. If the RBI increases interest rates to prevent this from happening, growth in India will suffer. If it lowers rates, there could be additional pressure on the rupee. There may be episodes of high exchange-rate volatility, such as when the Fed announces the date of reducing its purchase of treasury bills, buys less bonds, stops them altogether, or when it starts reducing the size of its balance sheet.

It is well understood by now that once the capital account is open, a country has to choose between pegging the exchange rate and pursuing an independent monetary policy. The impossible trinity tells us that with an open capital account you cannot have both a pegged exchange rate and monetary policy independence. If the business cycles of the Indian economy were perfectly aligned with those of the US, there would be no problem. But if the US is going to raise rates, we have to make a choice: let the rupee be flexible or peg the rupee to the dollar and tighten along with the US. The middle paths that we try to follow are fundamentally problematic and may only have some limited, short-term impact. Meddling with the exchange rate can only be done by distorting monetary policy, and anyone who says otherwise is trying to obfuscate matters.

As the experience of the last couple of weeks shows us, decisions about monetary policy are not straightforward. First, there is no answer to what the correct level of the currency or interest rate should be. Countries witness deviations of the real effective exchange rate from the historical neutral level. This could be because the real effective exchange rate is not always the market equilibrium, as financial markets are influenced by many forces, or it could be that fundamentals, such as changes in productivity, are pushing it to a new value. Whatever the case may be, manipulating the real effective exchange rate to keep it constant or at the correct level, after accounting for productivity changes, at all times, is an impossible task.

Second, whether a currency should strengthen or weaken to stabilise the economy depends on what phase of the business cycle the country is in. When the economy is slowing down, a weaker rupee will help it recover, when it is overheating, a stronger rupee will help prevent inflation from rising.

Third, any policy action will have an effect not just on the currency but also on interest rates, growth, the fiscal deficit, the current account deficit, business sentiment and investment. There are costs and benefits. Both need to be considered.

These issues suggest that monetary policy actions should be made after thorough analysis, discussion and considering different points of view. Knee-jerk reactions that focus only on one element of the impact of those policy changes are bound to be troublesome. Since governments often come under political pressure to do something, if the job of making monetary policy can be influenced by the government, it results in macro-economic mismanagement. It was an understanding of these difficulties in monetary policymaking, after many episodes of painful mismanagement that led to years of inflation, recession, stagflation and largescale unemployment, that led advanced economies to hand over the task to central banks. They were given independence from the government and required to have structures such as monetary policy committees, which allowed informed decisions and a diversity of views.

Why do governments prefer such arrangements? Why do they allow central banks to be independent and pursue policies that are so important for the whole economy? One reason is the shift in responsibility, particularly for all the costs. Remember that there will always be some losers and some winners from any policy decision. In other words, there will always be voices that say that a decision was wrong and point to the losses it creates. Once the public accepts that it is the central bank that makes these decisions, the impact of criticism of the government for inflation or for depreciation or appreciation is limited.

With the Indian economy opening up in the last two decades, the difficulties of monetary policymaking have increased. By now, there have been many government committees which have suggested that it is time for India to move to a modern framework for monetary policymaking. India needs a central bank with independence and accountability, and with a professional monetary policy committee that decides monetary policy actions using well-defined instruments of policy. The latest of such recommendations is by the Financial Sector Legislative Reforms Commission, which has also proposed a draft law. While it may be very tempting for the government to be able to shape monetary policy at a particular point of time, it needs to understand that it will be well served by such a framework.

Does India need sovereign bonds?

Financial Express, 24th July 2013

RBI's defence of the rupee and statements of govt officials suggest the rupee has become too weak. instead of deluding themselves, policymakers might do better listening to what the rupee is telling them

In recent months, when government officials suggested that the Indian economy was still strong, most of us thought they were trying to talk up the economy. But RBI's moves to tighten liquidity and raise interest rates this week seem to suggest that the government really believes that economy is strong enough to absorb large shocks like the those meted out by the RBI. A careful cost benefit analysis of the actions of the past few days suggests that they may be making a very costly mistake. Sovereign borrowing would further add to this cost.

First, why has the rupee depreciated? India has a large current account deficit that needs to be financed by capital inflows. Ben Bernanke's statement suggesting that rates in the US may rise over the next few months led capital to fly out of EMs. Currencies that were being held up by capital flows witnessed sudden sharp depreciation. Along with India, other Ems with large CADs such as Brazil, Turkey, Indonesia also witnessed a sharp rise in currency volatility and significant depreciation. India's falling GDP growth, high inflation, poor investment sentiment and high current account deficit were unhealthy fundamentals to begin with. The US Fed provided the trigger.

Second, is depreciation bad for India at this point? It is bad for companies that borrowed overseas tempted by low interest rates. Those who don't have a natural hedge should either not have borrowed, or have hedged their exposure. On inflation, there may be little exchange rate pass through as the pricing power of companies in a low growth environment is limited. On the other hand, depreciation is good for export competitiveness and import substitution. Depreciation in a slowing economy can provide a demand stimulus to the economy. (Among the first signs already visible are tourists preferring domestic locations to foreign holidays.)

Third, even if depreciation is not good for the economy, can it be prevented? For a short while and at a very high cost, yes. Remember the basic principles of the impossible trinity: You cannot have a pegged exchange rate, an open capital account and an independent monetary policy at the same time. So we can give up monetary policy independence to peg the rate. We saw RBI do that with its interest rate defence. It raised rates despite having convinced us that despite the high inflation, the low growth in the economy had led it to lower its inflation forecasts, and the time for easing monetary policy had come.

So, yes, the rupee can be defended and it comes at the cost of raising rates at a time when the economy can least afford it. But with the tightening, the already poor sentiment about the economy, will fall further. RBI has argued that it raised rates not to attract capital inflows, but to kill speculation. So was the rise in interest rates,such as the call money rate going above its corridor to 9%, merely an unwanted and unexpected side effect? If so, it speaks volumes about the competence at RBI. And if not, it suggests that RBI is engaging in doublespeak where it is tightening liquidity that leads to higher rates,while suggesting that it is not tightening monetary policy as the repo rate has not been changed.

Fourth, are there any quick-fixes available? While the rupee may go up, the fundamental problems of the economy that have lowered productivity growth remain unaddressed. In the long run, if productivity growth in an economy is weak, it should be expected that its currency will depreciate. So, even if RBI is able to prevent further rupee depreciation for a while, unless the government addresses issues of infrastructure, land, labour, access to finance and the innumerable hurdles to investment and productivity growth in the economy, the rupee will continue to weaken in the long run.

RBI's defence of the rupee and the statements of various government officials suggest that the rupee has become too weak, that the fundamentals of the Indian economy are stronger than what the currency market is suggesting and the rupee should in fact be stronger. In other words, they believe that the market is wrong in thinking that there are fundamental weaknesses in the Indian economy. Instead of deluding themselves, policy makers might do better listening to what the rupee is telling them.

The taming of the rupee...

Financial Express, 12th July 2013

On July 8, 2013, the Reserve Bank of India (RBI) stopped all banks from carrying out any proprietary trades on currency derivatives exchanges. This means that all rupee transactions will have to be done only when a client approaches for selling or buying foreign exchange.

On the same day, Sebi doubled the margin requirements for forex trading, reduced client limits from the "higher" of 6% (of open interest) or $10 million to the lower of the two, reduced trading member limits from the higher of 15% or $50 million to the lower of the two.

While the RBI notification states "risk management" as the subject of the regulation, the Sebi circular mentions no reason for carrying out the measures.

Apart from these formal notifications, there have been some other eclectic interventions in the markets by RBI. State-run oil companies have been asked to meet their dollar requirements from a single bank (July 9). It seems banks were asked not to make predictions about the rupee in their forecasts to the public.

The harsh reality is that these actions will not help stem the fall of the rupee; in all probability, they make things worse. These arbitrary moves to curtail economic freedom will only worsen the panic and irrational sentiment in the country. As an example, the only country where economic policymakers interfere with freedom of speech is Argentina. It is not good for India to be one of those who curtain freedom of speech on economic issues.

The rupee has become a big global market that is beyond the control of RBI and Sebi. Since 2007, the trade in non-deliverable forwards (NDFs) in the rupee has soared (see figure 1). These contracts are traded in London, Dubai and Singapore and many other locations. Since the rupee is a controlled currency, the settlement happens in foreign exchange. Indian policymakers have succeeded in crippling the growth of rupee trading in India, but they have no say in interfering with the global trading of the rupee. The overseas market has increasingly come to dominate the rupee (see figure 2).

What the RBI and Sebi moves have achieved is to reduce liquidity in the market. This will allow RBI's intervention to have an impact. But this impact is only in the short run. In the long run, trying to create walls between domestic and offshore derivatives markets for the rupee, or in squeezing the size of the market will have little impact on improving India's competitiveness. The lack of growth in productivity and high inflation will weaken the currency and will come back to haunt the economy.

These moves will, however, make the economy less resilient. RBI and Sebi are successful in reducing access to risk management for small companies in India. For any reasonable-sized organisation, the highway is open to take money out of the country and participate in the overseas market.

In the 1970s, Indira Gandhi's government used to think that food price inflation was caused by hoarding of food. Stringent actions were taken against speculators and hoarders. These made no difference to the supply and demand for food. We now recognise that such authoritarian actions are useless in obtaining cheaper food; the path to cheaper food lies in deeper initiatives that increase productivity in agriculture.

In a similar fashion, the government's assault on the rupee market is inspired by the idea of attacking market participants when the market price is considered undesirable. This will fail again. The price of the rupee is ultimately about supply and demand, and about India's prospects. It is convenient and fashionable for policymakers to blame market participants, but the deeper cause of the rupee's decline lies in the macroeconomic mismanagement including high inflation and large deficits. Until those fundamentals are addressed, the rupee will not improve.

The vast global market for the rupee will gladly lap up all the participants that are driven away from the market within India. RBI and Sebi can drive rupee trading out of the country; they cannot prevent it. Indian policymakers will ineffectually preside over an empty and irrelevant corner of the global market for the rupee. It is ironic that recent moves by RBI and Sebi will accentuate their irrelevance.

India has rapidly integrated with global markets. The rupee and the Nifty are signs of the performance of the economy. When economic policy goes astray-as it has in recent years-this will generate instant feedback with a drop in the rupee and Nifty. This is a healthy feedback loop. It immediately brings pressure upon the political authorities.

Emerging markets have understood these lessons. The economic policy apparatus of mature emerging markets knows that it is judged by domestic and global financial markets every day. This pressure has resulted in attempts at improving institutional structures. When bad things happen, the currency and equities are punished. The job of the government should be to try improving the policy frameworks. We, in India, have yet to come to the point where policymakers read these signals as weaknesses in the economy that they need to address.

Losing currency

Indian Express, 10th July 2013

To shore up rupee, policy must boost domestic productivity, assure foreign investors

The sharp decline in the value of the rupee in recent days has led to a clamour for the government to do something. But there are few easy options available. RBI intervention is likely to have limited impact in the face of the huge pressure on the rupee caused by global capital movements. Domestic interest rates cannot be raised to attract foreign inflows because of the decline in growth and investment in the country. Reducing imports though imposing restrictions on gold has had limited effect. The falling rupee is a consequence of global developments as well as a sign of longer-term features of the Indian economy. Addressing the symptoms, that is, the rupee fall, could give us short-term relief, but soon the same problems will surface again.

First, let us place the rupee decline in perspective. When we compare the slide of the rupee to the behaviour of other currencies in June, when the rupee depreciated sharply, it appears as if other emerging economy currencies depreciated less, while the rupee fell sharply. However, when we compare the rupee-dollar rate to other large emerging market (EM) economy currencies, like those of Brazil, South Africa, Korea or Turkey over a longer period, starting in January 2013, we find that most of those currencies had depreciated earlier, particularly between mid-February and mid-March, while the rupee had held up. The US dollar trade weighted index shows similar trends. As a consequence, what appears to be a very sharp depreciation compared to other large EM currencies is not such a sharp depreciation. Indeed, if the rupee had not depreciated, it would have lost competitiveness against other currencies. With high inflation continuing to plague the Indian economy, the recent depreciation has prevented the real exchange rate of the rupee from becoming overvalued. As long as inflation in India is higher, in the long run we are likely to get a nominal depreciation that would prevent real exchange rate appreciation. So if our cost of production is growing at 10 per cent while, say, for the sake of argument, the others are at zero, then after five years, do not expect that the rupee will remain at 60. It should be expected to depreciate. By how much will depend on capital flows to and from India. For instance, earlier in the year, foreign capital continued to flow into India and the rupee did not fall.

The short-run approach to reducing the pressure on the rupee has been to curb imports of gold to lower the current account deficit. Recent evidence suggests two trends. First, official imports of gold have declined. Second, gold smuggling has increased. Government policies to reduce gold imports are aimed at official imports. It is not clear why the government believes that a shift from official channels to smuggling will solve the question of the inflow of gold or its impact on the rupee. It might have the naive faith that total gold imports will go down if restrictions are imposed, and the criminality it introduces into the system is a worthwhile price to pay for reducing the pressure on the rupee. But gold imports are a means of capital flight. If households do not have attractive assets to invest in, if real interest rates on bank deposits are low, if the real estate market is full of black money and scams, gold appears to be an attractive asset for households. Restrictions on gold have not made the rupee stronger.

Ultimately, a currency gets stronger if the economy witnesses higher productivity growth than the rest of the world. During the months that we have been worried about the rupee depreciating, the Chinese yuan has been appreciating. In addition, domestic inflation in China is high and wages are rising. This offers India an opportunity to step in when China inevitably loses its share of foreign markets. But for this, India needs to remove hurdles to the growth of large-scale industry in toys, textiles, engineering goods, household appliances and various consumer durables. This will involve changes in the exit policy of industry, labour laws, policies on foreign direct investment, removal of the infinite obstacles to investment, improving infrastructure such as power, fuel, raw material supply, ports and airports. Addressing these can give us higher productivity growth, which in turn would give us a strong rupee. But these are difficult problems to fix. India has barely begun to understand the problems we face in these sectors. We are far from fixing them. In all probability, we will helplessly watch Bangladesh, Pakistan and Vietnam step into China's shoes.

Today, India can achieve very little export growth through export subsidies or by directly pushing exports, even if the WTO rules allowed that. Most of the problems that stop domestic producers from becoming more productive and export to the world market are policy and infrastructural issues. Until now, our approach has been to boost exports by making policies to help "exporters". That approach needs to change towards policies that lead to an increase in domestic productivity. It is when firms become more productive that they start serving foreign markets. The challenge today is to create an environment in which more firms become productive.

Another element of the reform India needs to undertake urgently is to clean up its foreign investment framework. Today, the framework is so messy that even the government finds it hard to enforce its own rules. The alphabet soup of FDI, FII, FPI, QFI and so forth has no clarity and the legal uncertainty in the system is so high that it manages to turn away even those investors who want to bring money into India.

The time for quick fixes is over. The RBI must be complimented on seeing the problems of trying to implement a peg to the USD back in 2007-08 and moving to a floating exchange rate. Had Subbarao not been wise enough to do that, India would have faced a balance of payments crisis in trying to defend the rupee.