Future's rupees

Indian Express, 5 June 2010

In the last one month the rupee depreciated from 44.3 to 47 rupees to a dollar. Every time an administered rate mechanism is dismantled, there is a transition period where firms have to learn how to deal with price fluctuations. As India witnesses two way movements of the exchange rate, and higher volatility of the rupee dollar rate, firms will adapt themselves and become more resilient. RBI needs the nerve to not flinch in this period, of learning how to live with a genuniely market determined exchange rate.

On paper, India's exchange rate regime has not changed since 1994. It has been a `managed float' with the RBI announcing its goal to be to `contain volatility of the exchange rate'. No announcements are made about what these broad statements mean in practice. Sometimes this has translated into periods of preventing large movements in the rupee dollar rate. In other periods, it has been interpreted as attempting to prevent rupee appreciation. The fine structure of the exchange rate regime can be extracted from the data. Since 1994 there have been four distinct breaks in the exchange rate regime.

The exchange rate regime has been determined not just by events in the world such as the Asian and the Lehman crisis, but also by the identity of the Governor. The first experimental period when India moved away from an administered exchange rate to a market determined exchange rate, was led by Dr Rangarajan.

Following that, under Bimal Jalan, the rupee was tightely pegged to the US dollar with the RBI intervening regularly in foreign exchange markets. In this period, RBI had ample government bonds in its hands, through which the monetary distortions caused by currency trading were easily offset. This easy period ended towards the end of Dr. Jalan's tenure.

When Governor Reddy came in, at first, exchange rate flexibility was increased. But RBI then shifted gears to fighting appreciation. But now, currency trading was hard. Every time RBI bought dollars, it injected rupees into the economy. This resulted in persistent inflationary pressures. Every lever that RBI controls -- monetary policy, public debt management, banking regulation, securities regulation, capital controls, etc. -- was used by Dr. Reddy to focus on the exchange rate. The long-standing effort of phasing out CRR was reversed. The tools of prudential regulation of banking were pressed into service. Tactical details of issuance of government bonds were adjusted to suit RBI's need to undo the flood of rupees unleashed by its currency trading. Help was requested from the Ministry of Finance, for fiscal resources for this battle, through the `Market stabilisation scheme'.

Dr. Reddy was on the wrong side of history. When a central bank prevents rupee appreciation today, financial markets expect that appreciation tomorrow, which triggers off a capital surge into the country with investors seeking to profit from the coming rupee appreciation. When Indian companies expected rupee appreciation, it was advantageous to borrow in dollars and not hedge this currency risk. Capital inflows are driven by the policy stance of RBI on the exchange rate, and the Reddy regime sucked capital into the country.

Firms started taking on currency exposure on their balance sheets. This yielded huge costs for the Indian economy when the global crisis came, the rupee depreciated, and firms were hit with large damage on their balance sheets. The seeds of India's pain in the downturn of 2008-09 were laid in RBI's currency trading of 2004-2008.

This battle overshadowed Y V Reddy's period as governor. A cost-benefit analysis of this period is instructive. On the cost side, Reddy generated distortions of monetary policy, banking, securities markets, capital controls, public debt management and public finance. On the benefit side, Reddy subsidised exporters by giving them a free public sector umbrella of risk management services. Even this attempt broke down by March 2007, when exchange rate flexibility went up, despite all these efforts.

The choices faced by Governor Subbarao reflected a combination of this unhappy experience, and the global crisis. An attempt at going back to an administered rate would have been particularly hard given turbulent global conditions. In addition, if an emphasis on exchange rate policy were contemplated, it would entail distorting monetary policy, banking regulation, securities markets, capital controls, public debt management and public finance.

Early evidence suggests that this choice has been made in favour of shifting away from an administered rate. Barring one month of large currency intervention (October 2008), this period has involved a significantly greater extent to which we now have a market exchange rate.

As with cement, steel and other areas where an administered rate has been dismantled, it takes time for the economy to learn how to deal with a market rate. From March 2009 onwards, the rupee started appreciating. Pressure from exporters and some economists started. Had the RBI responded to those demands it would have got back into the difficulties that Reddy had experienced. But a market price never moves in only one direction. In the event, with bad news about Greece and the crisis in Europe, conditions changed, and the rupee started depreciating.

Allowing the rupee to move in both directions, up and down, induces healthy behaviour by private market participants. When the rupee is volatile, foreign investors do not think that the rupee can move only in one direction and start betting of the rupee. Higher volatility prevents firms from taking on unhedged dollar borrowings. Improvements in risk management, hedging using balance sheet as well as non-balance sheet methods makes firms more resilient to sharp changes in the exchange rate. Hopefully, Indian firms are now learning to live with a market exchange rate.

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