Let us waste 0.5 percent of GDP

Indian Express, 18 July 2007

On-budget sops for exporters, compensating them for rupee appreciation are a bad idea. But compared to manipulating the exchange rate, they are much less expensive for the common man. The hidden costs of trying to prevent rupee appreciation include inflation and capital controls which hurt growth and incomes.

What is the logic of compensating exporters? Primarily that the RBI gave no warning to exporters that it was suddenly going to give currency manipulation a short break and the rupee would appreciate. Exporters had been lulled into a sense of false comfort and were holding unhedged currency exposure. The sudden and sharp appreciation of the rupee vs the US dollar was unexpected, and in so far as they had based their expectations on the basis of past RBI behavior, exporters are justified in feeling outraged.

The compensation package offered consists of largely two parts -- an interest subsidy and exemption for domestic taxes that exporters should, in an ideal world, not have to pay. The interest subsidy component is particularly ironic because the hike in interest rates has resulted from an exchange rate policy that attempts to help exporters. For many years now, the rising pressure on the rupee to appreciate was prevented by the RBI by buying dollars and thus injecting rupees into the economy. It was to counter the effect of this liquidity injection and the subsequent inflation that the RBI raised interest rates. If anything, it should be the non-exporters who should get an interest rate subsidy since they are paying the cost of keeping the rupee weak for exporters!

Yet, despite all its drawbacks and unsavoury connotations, any on-budget mechanism to subsidise exporters is better than currency manipulation. Market manipulation of the currency market by RBI to deliver an undervalued exchange rate is seen by many people to be costless. However, a careful examination reveals that it is very expensive. The first and most direct cost is the fiscal cost of sterlising this intervention. The returns on the reserves portfolio are poor. Market Stabilisation Scheme bonds incur interest payments.

But these fiscal costs are only the directly visible costs. The most damaging costs are those that cannot be measured. Among these are the cost to the people of India of keeping imports expensive, and the inflation that results from greater liquidity. All instruments of monetary policy have become focused on trying to counter the effects of currency manipulation. And, yet, given the ever larger size of the market manipulation required, they are increasingly losing their power.

If one chooses to manipulate the currency today then one can choose only one of the other two pillars of the impossible trinity -- foreign capital flows or a low inflation rate. Two alternative policies are being suggested to grapple with this present challange posed by the impossible trinity.

The first proposes that we continue the policy of sterlised intervention by increasing the issuance of MSS bonds. A careful examination of the magnitudes involved shows that this is actually an infeasible path. First, there is a fiscal cost which could, within a year or two, run up to about Rs 25,000 crore per year. The second, and a much more worrying consequence would be that it would make the rupee much more attractive for global financial speculators and invite futher capital flows. If it were known that the government would issue unlimited MSS, it would be clear that the RBI would continue intervening in the market delivering low currency volatility. This umbrella of free public sector risk management would increase capital flows to India, worsening the pressure on the rupee to appreciate. Due to these problems, RBI has been forced to do only partial sterilisation in the post-2004 period, which has (in turn) ignited inflation.

The second proposal is to increase capital controls. Should we ban participatory notes by FIIs or should external commercial borrowings (ECBs) of companies be blocked? Blocking ECBs would hurt the investment plans of Indian companies who are today leading the 9 percent GDP growth. And, after all, Indian companies are looking to borrow from abroad because domestic interest rates have been raised to support the currency regime. It will be unfair to make Indian companies suffer on many fronts: an undervalued rupee that pushed up their import costs, an inflationary environment that pushes up their domestic labour and raw material costs, high interest rates that result from a mess in monetary policy, and lastly barriers to borrowing from abroad. This policy path involves saving a garment factory that exports at the expense of a power plant is going to be build with capital from abroad.

If we do not block foreign borrowing, will we block FII flows? Even a hint by the government of restrictions on FII flows can give us a Thailand-style crisis. These choices are very unpleasant and can destabilise the economy.

The best path for India might be to ignore the pleas of exporters who demand an umbrella of free public sector risk management and focus on augmenting exports through better infrastructure and labour law. But the government does need to ensure that NSE and BSE are able to build sound currency derivatives for the purpose of risk management, so that each exporter can buy his own risk management services from the market. And, if the pleas of exporters are politically unstoppable, an explicit on-budget sop is better than distorting monetary policy. If wasting 0.5 per cent of GDP a year on such an explicit on-budget subsidy is the price to be paid for a sound monetary policy, it is a very good deal for India.

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