Stop controlling

Indian Express, 19 December 2011

The RBI has imposed numerous controls on currency derivatives to prevent rupee depreciation. In the days of command and control a number of prices, including those of sugar, cement, steel and the Indian rupee were controlled by the government. A central them of India's reform after 1991, where the first big step was a 25 percent devaluation of the rupee, has been getting government out of setting prices.

Couched in phrases straight out of 1970s Indian economic policy, RBI has claimed that the problems of the rupee were caused by speculators. In the short term controls on derivatives have stemmed the depreciation, but will controls correct the problems of macroeconomic weakness, higher inflation, high fiscal deficits, bad governance, large subsidy programmes and the poor investment climate, which underlie the weakness of the rupee. The sooner we accept that we have problem in the economy, instead of trying to put the blame on speculators, and the sooner we address the fundamental issues without trying to shoot the messenger, the sooner will we be able to solve them.

In pre-reform India, the policy maker claimed to know the correct price of cement, and used State power to force this price upon the economy. But this worked fairly badly - government actually has no way to know what is the right price of cement. Hence, prices like cement and steel were decontrolled. At first, there was a lot of grumbling. Fears that speculators and hoarders would profit and destabilise the economy were common. But these changes were critical for India to become a market economy.

By the early 2000s, there were only a few prices such as petroleum products, food and fertilizers left where the government exercised control. The most important price of the economy, the exchange rate, was, however, one of these. From 2002 onwards, RBI got into one episode after another of trouble, on account of trying to set the exchange rate. At first, it seemed easy. From late 2003 onwards, the trouble started showing up. From 2004 onwards, as the market for the rupee grew bigger with increasing globalisation of the Indian economy, it started getting hard, and RBI was forced to accept a bigger and bigger role for the market in controlling the exchange rate.

From 2007 onwards, by and large, the market has determined the price. But the battles fought by RBI from 2004 to 2007 in trying to set the exchange rate pushed up inflation. From February 2006 till today, in every single month, CPI inflation has exceeded 5 per cent. The roots of India's inflation crisis lie in the improper monetary policy that was followed from 2004 to 2007, in trying to control the price of the rupee.

From 2007 onwards, we have had a new phenomenon in India: an exchange rate that fluctuates based on market forces, one that is not fixed by the government. After Dr. Subbarao became governor, he underlined this policy regime, by fully stepping away from trying to manipulate the market. But as with all market price fluctuations, exchange rate fluctuations is not without its problems. Exchange rate fluctuations became a new source of risk, from 2007 onwards. Alongside the shift to a market economy, there is a critical requirement of the tools through which market economies manage risk. These tools, called `financial derivatives', include currency futures, currency options, currency forwards, etc. Through these tools, a person exposed to currency risk, who does not like to face that risk, can enter into an insurance-like contract that eliminates this risk.

In the months leading up to 1991, India had a large fiscal deficit, a rising current account deficit, slowing growth and high inflation. The policies of command, control, banning financial markets, derivatives products, and market determined prices did not yield a fast growing healthy economy. The decision to undertake reform that would free prices and allow them to be market based was an essential element of the liberalisation process.

As a first step the rupee was sharply devalued by 25 percent, in line with the poor fundamentals of the economy. The "black market" for the rupee was already showing the mismatch between the official exchange rate that reflected the belief of the RBI about what the rupee should be, and the "black market" rate that market participants believed was correct. A devaluation was also seen, as in most economic reform packages, as an instrument that would help to push demand in a weak economy. Domestic industry that competes with imports becomes more competitive. Exports become more competitive. The second step in the reform process was to lay the foundations for the rupee to become market determined in the years to come.

In recent weeks we have had a sharp depreciation of the rupee. This depreciation is rooted in the problems of the Indian economy. The India story is now suspect. It is no longer clear that India will continue to grow at a trend rate of 7 per cent or more. Under such circumstances, it is sensible and reasonable for the market to deliver a sharp currency depreciation.

This policy move by RBI is a problem for two reasons. First, when a thunderstorm erupts, it is a failure of thinking when the government attacks the production of umbrellas. At a time like this, India should be going after all manner of financial sector reforms, which increase the range of currency risk management options and the depth of those markets so as to support big transactions. Instead, we have turned socialist.

The second problem is that this move by RBI falls right into the stereotype of India as having a low quality economic policy capability. The number one problem that India suffers from today is that the private sector - either in India or abroad - has lost respect for the economic policy process. The private sector believes that Indian economic policy lacks analytical understanding and political will. RBI's move falls right into the stereotype of Indian policy makers as trapped in 1970s ideology, of a government that lacks high quality professional staff that understands economics and finance. This further damages the commitment and investment into India on the part of the private sector, in India and abroad.

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