Change in course?


Nearly two weeks of little intervention by the RBI has given a sharp appreciation as the rupee catches up with market fundamentals. This has led to speculation about whether RBI's currency policy has changed. A number of explanations have been offered about why RBI's policy might have changed. However, questions about why there is a change in policy should be asked only after we know that there has indeed been a change in policy.

How do we know what is RBI's currency policy and whether it has changed? Surely, if people believed what the RBI says i.e. that the rupee is market determined, they would have believed that there was no change in policy. However, discussions last week indicate that RBI's official stance is not believed.

This is not surprising. Central banks all over the world are known to lie, especially about currency policy, so why should anything different be expected from the RBI? The systematic pattern of central banks that lie about currency policy was noticed in the international literature a couple of years ago. Until then research on the impact of currency regimes (fixed, floating etc.) on growth was based on the official classification of the exchange rate regime. Researchers got very unsatisfying results. They then turned to the question: were central banks telling the truth when they claimed that the exchange rate regime was fixed or floating? It was observed that in more than half the countries where the exchange rate was claimed to be market determined, there was heavy market manipulation to ensure that the exchange rate did not truly float.

In reality such central banks often "peg" the exchange rate. The term pegging needs to be explained. Pegging is not the same as a fixed exchange rate. It is a regime under which the central bank trades heavily to influence the exchange rate versus one particular international currency. So, for instance, if a central bank focusses on the US dollar, it trades to prevent significant movement of the domestic currency against the US dollar. Countries in the British Empire tended to peg their currencies to the Pound Sterling. French colonies tended to peg their currencies to the French Franc. For many years the German Mark became the currency to which countries in Europe would peg their currencies.

How can an external observer cut through the maze of claims about a "market determined exchange rate", and tell whether pegging to a given currency is afoot?

One way of defining a peg asks if the probability that monthly exchange rate changes remain within a one percent band with a probability of over 80% over a five-year period. The exchange rate may go through periods of both appreciation and depreciation. As this definition shows, this currency has extremely little flexibility.

In such a situation, the volatility of the domestic currency against the USD becomes low. However, the volatility of the domestic currency against other currencies becomes as high as that of the USD against them. Moreover, changes in the exchange rate versus a numeraire (a currency which does not figure in the country's trade or capital accounts) are explained by changes in the exchange rate of the USD against the numeraire.

Coming back to the recent discussion in India, what market participants need is to cut through official claims of RBI, and decipher the de facto currency regime.

What is the evidence on the currency regime in India? Recent research has provided evidence that the rupee has been pegged to the US dollar since 1979. The flexibility of the rupee versus the US dollar has not increased even after the rupee was supposed to have become "market determined" in 1993.

While the daily volatility of the Indian rupee versus the US dollar, has been around 0.1 per cent per day in the last two years, that against the Euro and the Japanese Yen (JPY) has been around 0.7. This matches the USD/Euro and the USD/JPY volatilities of around 0.7. RBI claims to want to "contain market volatility", but the INR/EUR and INR/JPY volatilities are exactly as large as those found with a market determined rate. This telltale pattern in volatilities constitutes very persuasive evidence of pegging.

Further, the changes in the exchange rate of the rupee versus the Swiss Franc (CHF), an unrelated currency, can be almost fully explained by changes in the exchange rate of the USD/CHF and not by other currencies such as the Euro or the JPY. These tests are based on "Frankel-Wei regressions", and they are a powerful way to catch the conscience of the currency regime.

This battery of evidence suggests that currency policy in India has consisted of a low-volatility peg to the USD. While this is quantitative and scientific and satisfying, this evidence is not surprising to anyone who has been watching the behaviour of the rupee.

In the last two weeks there have certainly been a few large moves in the INR/USD rate. But is this a change in regime? Was the current rate merely a target to which the RBI allowed the exchange rate to move sharply to? Is the RBI now going to go back to tightly controlling the movement of the currency? Or, will the rupee be allowed to have greater volatility in the future?

In other words, has the currency regime changed? Given that central banks are nontransparent, we need to look at the data. Two weeks is too little time to tell. Perhaps 100 days will be enough to get a sense of what is going on.

In the meanwhile, the market will continue to play guessing games with the RBI.

As mentioned above, the RBI is not alone in its official stance on the currency regime. Some literature suggests that central bank intervention is actually more effective when the central bank lies. In that case, central banks should lie.

The question that needs to be addressed is whether lying by central banks is a sustainable policy? A similar question has been asked in the literature on monetary policy. It pertains to the credibility of the central bank and its effectiveness in raising output and employment. It has been observed that a central bank can be effective only as long as it is credible.

In the case of the currency policy also, while lying may have short-term benefits, it cannot be a sustainable policy. It leads to a loss of credibility. In the case of monetary policy the cost of the policy became clear when the US economy witnessed many years of stagflation. Hopefully, the change in the case of the currency policy will come about before a heavy price is paid.

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


Ila Patnaik


Ila Patnaik
ipatnaik at ncaer dot org