Dining with the devil

Business Standard, 3 March 2004

In a recent lecture, Larry Summers observed that the financial crises of the 1980s were not situations where `innocent' countries were somehow overwhelmed by a flood of capital from a `herd' of speculators. They were, instead, situations in which countries made very active efforts to "dine with the devil (speculators) and ended up on the menu."

Larry Summers went on to make an important link between the problem of short-term capital flows and `pegging' - the kind of currency market manipulation that many central banks seem to like. He said that the implicit exchange rate guarantee entailed in pegged exchange rates formed a "particularly pernicious subsidy to short term capital." These countries had actively invited short term capital flows.

In India, the RBI says that "in the long run", the rupee will respond to fundamentals, but "in the short run", they will trade actively to "control volatility". This means that if you are an FDI or FII investor, with a five/ten year outlook on India, you have to bear the full brunt of the currency risk on the rupee. But if you are a short-term speculator, with a one-month horizon, you know that RBI is there to protect you.

How big is this subsidy to short-term speculators? In a previous article (Business Standard, February 18, 2004) I had estimated that in 2003-04 the cost of maintaining the rupee-dollar peg could work out to roughly 1% of GDP or Rs.28,000 crore.

India faced a fork in the road recently. With the decision to issue Rs.60,000 crore of Market Stabilization Bonds, the status quo on the currency regime won. The step has given a clear signal to foreign investors, who have been awaiting the outcome of the RBI's proposal to MoF with bated breath. Thanks to this decision, the RBI can continue to provide a low rupee-dollar volatility. Short-term capital flows can enthusiastically get back to making money at the expense of the Indian taxpayer.

The problem of currency regimes, pegging, short-term flows and the fiscal costs of currency market manipulation are not new to India. They have been amply studied through experiences of myriad other countries. The consensus of this literature may be summarised as follows.

The first key message is that pegged currency regimes are innately vulnerable to speculation. People will make forecasts about the future of the rupee, and they will act on these forecasts. We are building up a large mass of short-term capital in the country. This short-term capital is motivated by simple forecasting of a "low volatility" exchange rate. This short-term capital has nothing to do with India's glowing GDP growth. Last year, with low growth and a bad monsoon, currency speculation was merrily generating capital inflows.

There is an absolute certainty that the rupee will not appreciate forever. At some point, expectations will turn. This turning point can be triggered off by a wide variety of seemingly small shocks. Changes in international money markets, changes in the domestic environment, border conflicts, nuclear explosions, bad monsoons or any small shock that change expectations can be the trigger. Shocks which would normally have been absorbed by the economy, can become the cause of large capital movements. The elections will give us a fresh draw of the cards, and for all we know, we could have a hung parliament which suspends economic reforms.

Some trigger point will come. Overnight, the focus can shift from India's growth potential to her internal debt trap. At that point, the currency speculators will leave, and locals will move capital offshore in speculating on a rupee depreciation.

At that point, RBI will claim that this massive hoard of reserves is useful in coping with these cross-border capital movements. But it is important to see that these short-term flows, and currency speculation, are all caused by RBI's original sin of pegging to the USD. This decision has given a hair-trigger vulnerability to the macro-economy.

The next big lesson from the literature, on which there is a complete consensus, is that sterilised intervention is an extremely short term and fairly ineffective policy. As it invites further inflows, it does not solve the problem of short term capital inflows or the pressure on the currency. It has been observed that countries that follow the policy of sterilised intervention see a change in the composition of inflows in favour of short term inflows and away from long term flows.

In India, RBI's policy of sterilised intervention is claimed to ensure low currency volatility and low inflation. This offers an ideal breeding ground for short term investors. What RBI also ensures, by the sale of bonds in the domestic market, is that short term interest rates remain high. In a normal market economy, inflows are equilibriating since they would drive down local interest rates. Sterilised intervention fights that equilibriating response of the market, and lays a red carpet for continued short term inflows.

Where are we headed? For a while, the inflows will continue, and RBI will keep subsidising short term currency speculators without a care about the fiscal costs. Another USD 20 billion could come in 3-6 months. We cannot say whether when Rs.60,000 crore is used up, will Parliament continue to feed the elephant, or will the currency regime change?

At some point, expectations will change, and there will be a sharp reversal and pressure on the rupee to depreciate. The short-term capital in the country will leave. The liberalisation of outflows of recent months has generated many avenues for locals to shift capital out of the country, to profit from a rupee depreciation. RBI will `heroically battle the speculators', and peel reserves in addressing the problem of its own making.

It could get worse. As in Jan 1998, there could be harsh efforts at raising interest rates in `defending' the rupee. These could do damage to the banking system, given the interest rate risk of poorly regulated banks in India. There could be efforts to roll the clock back on economic reforms, and go back to capital controls.

By signing on to the Market Stabilisation Bonds, Jaswant Singh has signed on for this roller coaster. It is important to be very clear that all this flows from one single policy mistake: a pegged currency. If India did not peg to the USD, these problems would not lie in store for us. We would not be wasting roughly 1% of GDP at a time of acute fiscal stress, and running the risks of all these destabilising events.

RBI has never explained what it is doing. Why is pegging optimal? Why is it so important to reduce short-term volatility? Why is it good to favour short-term speculators? What is the benefit for which we are burning 1% of GDP at a time when we should be cutting the fiscal deficit by 1% per year? This is the most non-transparent large expense being paid for by the Indian taxpayer.

Jaswant Singh added the expenditure on MSBs to the exchequer after his interim budget. He owes to the people a full explanation of the costs and benefits of this policy.

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

Ila Patnaik

Ila Patnaik
ipatnaik at ncaer dot org