Fear of floating

Indian Express, 21 March 2005

The current rupee-dollar rate is a false one sustained by massive RBI buying

Is India moving away from its loyalty to the dollar? The greater flexibility of the rupee-dollar rate last year, and changes in how we hold foreign exchange reserves, do suggest that India may be one of the pioneers in getting out of harm’s way of the weakening US dollar.

Data released earlier this month from the Bank of International Settlements (BIS) shows that the RBI has reduced its dollar holdings in foreign currency reserves from 68 per cent to 43 per cent during the last three years. China lags behind India, and has dropped from 83 per cent to 68 per cent during this period.

This is progress. But at the same time, there is disturbing news. In the period from March to December 2004, RBI had loosened the extent of pegging of the rupee-dollar rate. The flexibility of the rupee-dollar rate had more than doubled in the period from March 2004 to December 2004, as compared with the preceding year. In the period before April 2004, the rupee-dollar rate would not generally be allowed to move by more than 15 paise on a single day. After April, it moved by even as much as 60 paise on a single day. However, in 2005, the rupee-dollar rate is back to moving within a very narrow band. After February 11, the daily move has been smaller than 10 paise on all days.

Why did currency flexibility go down? Data for RBI’s trading is available only till December 2004, but reserves data is available weekly until March. A small calculation enables us to roughly disentangle changes in reserves due to changes in the euro-dollar rate. We are then able to arrive at an approximation of the weekly trading by the RBI. The results are startling. Every week since February 5, 2005, RBI has purchased between 1.5 to 2 billion dollars. This scale of trading is similar to the worst period of April 2004. The rupee has been prevented from moving by more than 5 to 8 paise per day by heavy trading.

This strategy is a very dangerous one. And this is not merely because India already has more than enough reserves and is actually worrying about how to get rid of a part of them. It is dangerous because it sends out a signal to the world that the currency is not at its correct price. The current rupee-dollar rate is a false one, which can only be sustained by massive buying by RBI.

The lesson from that experience was clear. Tightly pegging the rupee is beneficial to currency speculators, and leads to big movements of capital across the border. To think that administrative controls can plug the leaks at each of the thousand holes of the sharply globalising Indian economy is a pipe-dream. Dollars will now flood in from every nook and cranny, in the form of false export proceeds on gems and jewellery, as invisibles such as “software exports”, as loans and gifts, in NRI accounts and as FII flows on the equity markets. Today, gross inflows and outflows on the trade and capital accounts constitute about 55 per cent of GDP. To try and outsmart the thousands of people who are finding ways to bring in dollars today and take them out later when they get more dollars per rupee, is a futile exercise. RBI’s game of trading intensively to mis-price the rupee is just giving these people windfall profits.

When a central bank runs a tight peg through active trading on the currency market, it comes at a very high cost. RBI buys up dollars in the currency market in exchange for rupees. This leads to an increase in the supply of rupees in the economy. To avoid an increase in money supply which may cause inflation, RBI tries to partially suck rupees out of the domestic economy. This is done by selling government bonds, usually to banks. But through this process, RBI replaces high-yielding government bonds on its balance sheet by low-yield foreign currency bonds. This induces “quasi-fiscal costs”, by reducing the dividend paid by RBI to the government and ultimately showing up as a cost to the central government.

The cost of RBI’s attempts at currency trading are visible and ran into tens of thousands of crore. What were the benefits? Indeed, after the policy changed in March 2004 — with a big rise in rupee dollar volatility — there have been no protests from any quarter. In that case: who was benefitting from the old regime?

Another unanswered question is: Why did currency flexibility go up after March 2004? One explanation was that the tight peg was consciously abandoned because it was inviting too much foreign capital. The Indian economy was doing well, attracting foreign capital. Expectations of appreciation were making it worse. Breaking with the peg in March 2004 put an end to the currency speculation. But RBI’s purchase of dollars in the market last month suggest that this explanation must be wrong. If the RBI had drawn lessons from their previous discomfiture, it would not have reverted to their old ways.

Finally, there are serious gaps in transparency. RBI is trading with public money, and the currency regime affects the larger public: but all these activities take place in secret. We are forced to reconstruct facts about RBI’s trading using scraps of data that come out from an agency in Switzerland (BIS). The last time the peg was loosened, no warning was given to exporters and importers about the much higher currency volatility that was in store. If RBI had made announcements, then firms could have taken hedging actions in response. A central bank that swings from one currency regime to another in such non-transparent fashion is generating risk for the country.

Ila Patnaik

Ila Patnaik