Dr. Jalan's dilemmas

Business Standard, 3 September 2003

In one of his last speeches as RBI governor, Dr. Bimal Jalan has invited debate and discussion on India's currency policy. In one of the most candid statements made about the difficulties being faced by RBI in trying to manage the rupee-dollar exchange rate, Dr. Jalan said:

"In principle, therefore, it would be nice if an alternative viable exchange rate management system could be put in place which would avoid excessive build-up of reserves and domestic liquidity and, at the same time, maintain India's external competitiveness with low inflation and low interest rates."

Dr. Jalan's greatest achievement as RBI governer was the opening up of the capital account. For most practical purposes, India now has an open capital account, and very large sums of money can move up and down the national border. There is a delicious irony in that this major achievement has undermined the policy framework for the currency which had been in place from 1979 onwards. There was a time when RBI could have monetary policy and exchange rate policy. There was a time when RBI could have all the nice things described by Dr. Jalan above. That time has passed.

With an open capital account, there is a paradigm shift, which RBI is now learning the hard way. The speech is also a message to future policy makers at RBI and the government that the way forward is not to reverse the progress made by Dr. Jalan on liberalising the capital account. New policy paradigms need to be found, which are consistent with the impossible trinity of an open capital account, fixed (managed) exchange rates and independent monetary policy.

Dr. Jalan's speech reflects the limitations of the current currency regime, under which the RBI has been intervening heavily in the market to manage the exchange rate. Given the increasingly open capital account, a great deal of speculative capital is prowling, which makes money at the expense of a central bank trying to manage a currency. Interventions have led to an excessive build-up of reserves, which then have to be sterilised to prevent a sharp increase in domestic liquidity.

Dr. Jalan's views on the cost of these policies are striking. The speech says:

"So far as the cost of additional reserves is concerned, it needs to be borne in mind that the bulk of additions to reserves in the recent period is on account of non-debt creating inflows."

It is clear that the build-up in reserves that has taken place in the last two years (after the Millenium India Bond issue) have not been on account of borrowing by the government to hold dollar reserves. However, economists do not measure the cost of reserves solely as the direct cost of borrowing, but as the opportunity cost of holding reserves. In other words, dollars held in reserves are held in risk-less liquid assets eg. in US treasury bills. They earn among the lowest rates of return in the world. If invested elsewhere, they would earn a higher rate of return. The interest income foregone provides a simple measure of the cost of the reserves.

That is not all. When a central bank like the RBI is committed to a policy of keeping money supply under control, it also sterilises the reserves it holds through open market operations. An increase in net foreign exchange assets that adds to reserve money is matched by an equal reduction in net RBI credit to the government to reduce the impact on monetary growth.

In this process the balance sheet of the RBI shows a reduction in high interest earning domestic bonds and an increase in low interest earning foreign bonds. This reduces the interest income earned by the RBI and the dividends it pays to the government. The government however continues to pay interest income to the new holders of the bonds. Thus when the balance sheets of the RBI and the government are examined together, there is an increase in "quasi-fiscal costs".

The simplest illustration of the costs is one where an FII brings in $10 million. RBI purchases the dollars and holds them in (say) a 3 month US treasury bill. The FII then buys a 91 day treasury bill of the GOI. On the combined balance sheet of the government and RBI, the FII is now being paid a 5 percent on the GOI bond while GOI+RBI earns 1 per cent on a US t-bill. Owing to sterilised intervention, GOI+RBI is paying the FII a 4 per cent interest subsidy!

The third way in which the cost of reserves may be examined is to look at the investment foregone when reserves are piled up. While Vijay Joshi may disagree with Deepak Lal and Suman Bery on their estimates of the amount of growth foregone, what is not disputed is that a significant 3.5 to 4 percent of GDP is not invested owing to India's currency policy.

In a standard open economy model with flexible exchange rates, currency adjustment would result in a reduction in the current account surplus until savings equal investment. In the case of an open economy where the exchange rate was fixed, there would be purchase of dollars by the central bank, an increase in the monetary base and in money supply and a reduction in interest rates. Lower interest rates would increase investment in the economy till saving equal investment.

In the case of an open economy with fixed exchange rates, where the central bank tries to follow an independent monetary policy, there would be no adjustment in exchange rates as the central bank would intervene. There would be no adjustment in interest rates as the central bank would sterilise its intervention, and consequently the saving investment adjustment would not take place. It is the policy of sterilised intervention by the central bank that prevents adjustment from taking place.

India today is trying to have an open capital account, and trying to manage the exchange rate to maintain export competitiveness. In the process it builds up reserves. To talk of finding ways to "use" reserves, as if they are not the result of RBI's purchase of dollars, and as if the option of not intervening in the currency market does not exist, misrepresents the issue. It is not correct to argue:

"However, at the same time, it must be emphasized that there is very little that RBI, (or, for that matter, Government) can directly do to use additional reserves for investment."

Moreover, it is said that:

"The equivalent rupee resources have already been released by the RBI to recipients of foreign exchange, and equivalent rupee liquidity has already been created."

This is simply not true. The RBI has been actively sterilising the addition to foreign exchange reserves by both open market operations and repo transactions. Sterilisation of reserves means that equivalent liquidity has not been created! Indeed that is how liquidity in the economy has remained under control. If the increase in liquidity had matched the increase in foreign exchange reserves, the increase in money supply would have exceeded 30 percent in 2002-03. The sterilisation of reserves by RBI prevented excess domestic liquidity.

What Dr. Jalan says about how it would be nice if an alternative viable exchange rate management system could be put in place is very true. The current system has it benefits in terms of keeping India's exports competitive. However, it is incorrect to argue that:

"On the whole, under present conditions, it seems that the "cost" of additional reserves is really a non-issue from a broader macro-economic point of view."


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

Ila Patnaik