Dear Dr. Reddy,
You are coming back into RBI at a critical juncture. In the last ten years, there has perhaps not been a more interesting and challenging time for India's monetary and exchange rate policies.
The crawling peg currency regime, which appears to have served India well in the post 1998 period, is now coming under severe stress. High levels of capital inflows arising from interest differentials and currency expectations are a new phenomenon for India. To manage these inflows you will need to focus on expectations of market participants, something India does not have much experience in.
The most important danger in this situation is to fall back on controls. India's policy makers have a long experience of `solving' problems by tweaking administrative controls or creating new restrictions. A great deal of the staff of the government of India instinctively responds using such an obsolete intellectual superstructure.
In the last few years India has been able to achieve high growth because of the move away from the regime of administrative controls. Governer Jalan's greatest achievement has been a substantial easing of currency controls.
Time has perhaps dulled our memories of the horrors of currency controls. The distortions they introduce, the behaviours they reward, are far reaching. In our FERA world, we criminalised ordinary transactions, hobbled the trade and capital integration of India with the world, and created a Kafkaesque policing structure. We must resolutely turn away from that option.
It is true that the current situation is new for us. But we need new tools to respond to it and not fall back upon tried and failed ones. We have no option but to truly understand open economy macroeconomics and to confront basic questions about the currency regime and macroeconomic and monetary policy.
Let me paint a couple of scenarios which you should envision, and plan for.
We can visualise a 'good' scenario. The rupee continues to appreciate and capital continues to flow in. In this scenario we witness no external shocks. In the last 12-18 months, our crawling peg regime has converted a current account problem into a capital account problem. RBI prevents the rupee from sharply appreciating on any one day. So speculators know that the rupee will appreciate in the future. Every time speculators sell $1 billion to RBI at Rs.46 and take it back at Rs.45, RBI loses Rs.100 crore.
However, India is unable to absorb the capital flowing into the country. The outcome of the current regime violates the purpose of management of the exchange rate - to be able to allow India to invest more than it saves. To do that India needs to run a current account deficit. The objective of having an open capital account for a capital scarce, developing country is to be able to import capital such that domestic investment exceeds domestic saving. The route to higher investment is when interest rates fall with the inflow of capital. That allows the capital inflow to be absorbed by investment increasing and growth rising. If instead of a current account surplus of 1.5 per cent of GDP, India ran a current account deficit of 2.5 per cent of GDP, we would be investing 4 per cent more of GDP. This would significantly push up the growth rate.
A 'bad' scenario is one where there is an exogenous shock. Most crisis arise not by slowly and steadily walking into them, but by allowing conditions to arise where we are hit by unexpected shocks. A sharp change in conditions, for example, in international bond markets that push up interest rates in the US, could well create conditions for capital to flow out of India.
This could create turmoil in the market. It is difficult to say where the rupee would be in such an event. It is difficult to imagine a smooth transition to equilibrium. No doubt the market would see some overshooting and some intervention. The real implications of this will be painful. Many firms and banks in India will face difficulties owing to unhedged currency exposures.
It appears reasonable to think that you will use RBI's large kitty of forex reserves in coping with the exit of the hot money. You could easily use up $30 billion in defending the rupee. However, if you are also tempted to use interest rates to push up the rupee, it could expose a large number of businesses and households to high risks. The decline in interest rates over the last few years have seduced many borrowers to borrow at floating rates. When these rise, many could be pushed into bankruptcy.
However, even if there are no such nasty shocks to the system, and the present situation of high capital inflows continues, it is not something that is desirable. There is a need to think about how to solve the problem. The problem of high inflows that is not just arising out of disequilibrium in the market, but causing further movement towards greater disequilibrium.
Since the short term capital inflows are caused mainly by two factors: the interest differential and the expectation of appreciation, there is a need to address both these. Last week the RBI imposed an upper limit on NRI deposit rates. This step and the recent widening of the band in which the rupee moves on are indications that the RBI is trying to find a solution. However, moving towards administrative controls on interest rates should not be the default mode.
With $84 billion in your pocket, Dr. Reddy, you may consider this an appropriate time to make a soft landing to a new currency regime. RBI needs to shift to a floating exchange rate, so that the INR/USD exchange rate becomes a random walk and there are no unidirectional currency expectations. While hot money may leave the country, it is likely to happen more slowly than may happen if, under the current expecations of rupee appreciation, there is a sudden shock.
The conventional wisdom internationally has increasingly shifted in favour of a floating exchange rate, where the central bank seldom engages in currency intervention. As recent events have demonstrated, it is difficult to engage in currency policy once the capital account is sufficiently open. Monetary policy is something too precious to give up, in trying to achieve a tightly controlled exchange rate.
Today, you are well placed to handle a slowdown of inflows. You are well placed to handle a pressure on the rupee to weaken. It makes so much more sense to move before there is a crisis. No, doubt there will be difficulties but India is today ready for a change in currency regime. The next few months will hopefully see you head that change.
Ila Patnaik
ila at icrier dot res dot in