Feeding an elephant

Business Standard, 18 February 2004

Last week, our foreign exchange reserves crossed $106 billion. RBI claims that this hoarding is being done to insure against a rainy day. We were piling up reserves owing to the fundamental unfairness of the international financial architecture, it is claimed.

Recently, a more contemporary strand of thinking was visible from RBI. Their latest Report on Currency and Finance says: "It is important to note that the level of reserves held by any country is really a consequence of the exchange rate policy being pursued. In a fully floating exchange rate regime, on the other hand, the exchange rate would adjust itself according to the demand and supply conditions in the foreign exchange market, and as such there would be no need to take such inflows into the reserves."

If we no can no longer justify the pile up of reserves as insurance, and they are but a side-effect of RBI's currency regime, it is necessary to constantly measure the costs and benefits of this regime. The regime is one where RBI intervention aims at keeping currency volatility low, while sterilization offsets the impact of currency trading on money supply.

Let us look at the costs first. Manipulating the currency market through sterilized intervention imposes two kinds of costs. First, profits or losses are made by the central bank on account of the trading. Second, losses are made on account of holding low-yield bonds.

As an example, consider October 2003. Reserves in September 2003 were Rs.399,870 crore. In October, foreign exchange worth Rs.7130 crore was purchased from the market. Yet, reserves at the end of October stood at only Rs.401,872 crore. The discrepency is RBI's trading loss, which works out to Rs.5129 crore in October. In the period April to October 2003 the net loss was Rs. 6011 crore. (Some months saw profits as the rupee value of reserves held in Euro increased.)

The other component of cost is that arising from replacing high interest rate GOI bonds by low interest rate US bonds. The interest loss in the period April to October 2003 works out to Rs.8381 crores.

So RBI imposed a cost upon India, in April-October 2003, of over Rs.14,000 crore, or 0.5 per cent of GDP over roughly half a year. This is one expensive elephant to feed! Abandoning this currency policy could strengthen the fisc by roughly 1 percent of GDP per year.

As foreign exchange assets of RBI have increased, the RBI has sold government bonds, where its holdings are now down to $8.8 billion. If RBI were to issue bonds, like a number of central banks have, it would continue to bear the cost of the currency regime. To shift these costs to the GOI, a recent RBI committee has suggested that the government issue additional bonds called Market Stabilization Bonds (MSBs).

When the MSB proposal came out, I thought it was a good thing. The MSB idea is poor economics, of course, but I was happy because the MSB idea lays bare the fiscal costs that RBI is imposing upon GOI in its currency policy. Earlier, RBI's game has been more non-transparent, and only the cognoscenti understood the massive costs that the people of India are paying to sustain the status quo. I thought that the MSB would open up RBI's policies to greater questioning and scrutiny on the part of other actors in public policy formulation.

The sheer chutzpah of the MSB is breathtaking, and deserves elaboration. Over the last year, RBI has added $31 billion of reserves. So if RBI wanted a war chest to support a similar endeavour for the next one year, Rs.140,000 crore of MSB would have to be issued. But the moment the bonds are sold, going by the definition of the MSB, the proceeds would have to be held in an interest-free account at RBI. That money can't be spent (else it's not an MSB).

GOI would be saddled with an extra 5 per cent on the debt/GDP ratio, further damaging India's credit rating. GOI would have to pay (say) 5 per cent on these bonds, so there would be an annual interest cost of Rs.7,000 crore to support these bonds. I thought this is great - now members of parliament will ask what is the noble cause for which we are burning Rs.7,000 crore per year. Of course, as emphasised above, the full cost of the currency regime is much more than only the interest cost of the MSBs.

Interestingly, RBI has always been quite sanctimonious about the incompetence of expenditure patterns shown in problems like PDS, EPFO, etc, and has solemnly called upon New Delhi to question the status quo, execute better policies, and do a better job of its finances. There is a striking contrast that on home ground, RBI has no compunction in emulating EPFO or PDS; avoiding any change in its own lifestyle, and walking up to the Finance Minister with a bill in hand.

Undoubtedly the currency regime is a very costly policy. But, it is worth spending 1 per cent of GDP a year if the benefits are commensurate. What are the benefits? RBI generally emphasises two kinds of benefits. It is claimed that preventing rupee appreciation, and having low currency volatility, are good for the country.

The rupee has appreciated from Rs.49 to Rs.45, with no discernible effect in slowing down exports growth. In fact, imported goods have become cheaper owing to this appreciation, which is directly good for Indian consumers, helps keep inflation down, and fuels exports growth. It is not clear that lower currency volatility is particularly better. Cross-country studies suggest that there are plenty of countries with high currency flexibility, and they do fine, as long as the currency derivatives markets are allowed to function. RBI could downscale on manipulation of the currency market, and instead create a healthy currency futures market that reduces the adverse impact of currency volatility.

In fact, a manipulated exchange rate is bad in generating misallocation of capital - we are giving wrong signals to entrepreneurs which will be falsified when reality catches up with the manipulated price. Allowing higher volatility of the exchange rate is necessary to prevent one way bets on the currency. Today such one way bets have created a large inflow of capital that is leading to further mispricing of the rupee.

India is in a serious fiscal crisis. It is irresponsible to impose such costs when the need of the day is fiscal consolidation. There are central banks across the globe, who do exchange rate policy without seeking help from the fisc. Surely RBI has the ability to do so as well.

Jaswant Singh prides himself on containing the deficit and reducing government expenditure. So there is hope that RBI's status quo request will be spurned.

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