A change in course?

Rate cuts in major countries outside India, such as by the Fed last week, further increase incentives to bring capital to India. This intensifies the pressure on the rupee to appreciate. The traditional RBI approach, of putting currency policy first, would have suggested that RBI should also have cut interest rates.

RBI policies in the last four weeks have not been fully consistent with its traditional currency policy. First, the European Central Bank cut rates. RBI did not. Next, the US Fed cut rates. RBI did not. Third, large daily changes in the exchange rate have been more frequent in the last 4 weeks compared to the previous 12 months.

While the period 1 June, 2002 to 31 March, 2003 saw an average of less than 2 days a month when the rupee moved by more than 5 paisa, the months of May and June 2003, witnessed over 15 days such days. While the last financial year did not see any daily change of over 10 paisa, this year has seen over 10 such days already.

These things do not happen by chance. The above developments may signal a possible change in currency policy at RBI. If they do, this has implications for questions about the exchange rate, interest rates and liquidity in the economy.

In the face of higher interest differentials, what are the alternatives before the RBI?

First, it could continue with it's traditional crawling peg policy, where the rupee is not allowed to appreciate by more than a certain amount. In this, it could widen the daily band as seems to be happening. It could even allow rupee appreciation of 20 paisa/day or 30 paisa/day. Under this option it would continue with sterilized intervention that has defined its policy framework in 2002-03.

The second alternative could be to continue intervening to keep the rupee within a band, but to discontinue its policy of sterilisation.

Third, it could shift to a floating exchange rate regime and not intervene in the forex market. This would mean that the rupee would become a truly market-determined, random walk, exchange rate.

The first option, of preserving the status quo, is becoming harder to maintain. It requires more intervention, more purchases of dollars by the RBI and more sterilization of foreign exchange assets to keep domestic money supply under control.

Suppose the RBI continues to intervene in forex markets, even while broadening the band in which the rupee is allowed to move. Given the interest differentials with international rates, capital inflows would continue. A mere doubling of the amount by which the rupee is allowed to move will not change the picture significantly.

The RBI's exchange rate policy would require it to purchase dollars as it has been doing in the last 12 months. Then, it could either continue to sterilize its intervention, or it could let the increase in foreign exchange assets lead to an increase in reserve money growth.

This brings us to the second alternative. That RBI could continue intervening but stop sterilizing the impact of the build-up of its forex assets. The policy of sterilising inflows is usually followed when there is fear of inflation in the domestic economy. Under such circumstances central banks are willing to bear the costs of replacing low interest earning foreign bonds by high interest earning domestic bonds. But, if the fear of inflation is low, the cost of sterilising the inflows may not be justified.

Moreover, even if the costs of sterilised intervention on the balance sheet of the central bank are low, the policy has a cost in terms of hindering the normal self-correcting market process to work. Without sterilisation, currency intervention would lead to excess domestic liquidity, lower domestic interest rates, and hence reduce the compulsions driving capital inflows. With sterilisation, liquidity in the economy is not allowed to increase and the reduction in interest rates that the market may have brought about to reduce the interest differentials, does not take place.

In the months since June 2002, when the rupee has been slowly appreciating, the RBI consistently sterilized its foreign exchange interventions till January 2003. However, open market operations by the RBI have been significantly lower since then and data available till April 2003 suggests that net RBI credit to government has increased from Rs 1,13,913 cr on April 25, 2003 to Rs 1,19,304 cr on June 13, 2003. Net foreign exchange assets and reserve money have both grown by Rs 20,000 crores over this period. This suggests that RBI intervention was not sterilized in this period.

If this is true, and further purchases are also not sterilised, and/or other counterveiling measures to reduce liquidity sufficiently are not undertaken, then there would be an increase in money supply. Excess liquidity in the market may not necessarily be inflationary but does pose other problems, such as the impact upon domestic asset prices. Thus, the policy of widening the band or even giving up sterilizing may not be first best.

This brings us to the third policy option: that the RBI could stop intervening in the forex market and not keep buying more dollars. First, this should correct any misalignment of the exchange rate, if it exists. If, as RBI and many analysts argue, there is no misalignment, then this can hardly do any harm.

Second, if this does lead to a sharp appreciation of the rupee, compared to the slow appreciation that is being enforced by the current regime, then also it serves an important function. It ends expectations of further appreciation. This would prevent capital inflows that could be flowing in due to expectation of rupee appreciation.

A significant amount of the short term funds seem to have flown into India in the last 12 months on the expectation of an appreciation. It is likely that this money will leave once expectations of a rupee appreciation abate. When the exchange rate is seen to be at an equilibrium level and hot money has left the system, expectations should become more neutral. In addition, once the hot money leaves, RBI's forex reserves will be at more sensible levels, and consistent with the role of reserves as insurance.

While on the one hand, many economists would still argue that it is important to keep the rupee weak to push India's exports, on the other, it is also true that today a stronger rupee would make imports cheaper and allow greater import of capital goods and oil that could give a boost to the domestic economy. The investment stimulus that could arise from this could, in principle, be stronger than that arising from a weaker rupee. As the costs of fighting against the wind to keep the rupee weak grow, it appears to be an increasingly attractive option.

The author is at ICRIER. These are her personal views.

Ila Patnaik

Ila Patnaik
ila at icrier dot res dot in