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India's exchange rate conundrum

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In Brief

The debate on exchange rate policy tends to surface during periods of prolonged and undue appreciation. At its centre is the degree of flexibility that is beneficial for the economy as a whole.

The issue is not about following a policy of persistent undervaluation, as occurred in China, but to avoid excessive determination by capital account movements; the shift to a flexible exchange rate regime in 1998 being widely accepted. There is a trade-off between exchange rate deployment to attract foreign capital and macroeconomic stabilisation vis-à-vis growth promotion through exports.


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At the current critical juncture of global uncertainty and weak external demand, the exchange rate policy of the Reserve Bank of India (RBI) has shown a pronounced tilt towards exchange rate deployment. This has coincided with a change in leadership at the RBI. Does this result is an environment which is supportive of investors? And is this an international signal of commitment to financial liberalisation through progressive rupee flexibility?

The rebound of the currency from the depths following the September 2008 crisis is notable. Although its bilateral value in relation to the US dollar is now oscillating around its decade average, in real terms the rupee level equals the 2007 peak, when it was boosted by a prolonged surge in capital flows. The broad equivalence of the rupee’s real value to its cyclical peak raises concerns about currency drivers and their full reflection in exchange rate movements. Notwithstanding appreciation due to changes in structural factors such as productivity growth, the pace of currency normalisation has remained below the 2007 peak, whether measured by the official RBI or Bank for International Settlements’ (BIS) real effective exchange rate (REER) indices.

The current macroeconomic configuration is significantly inferior to the boom periods. The high rates of export growth have reversed into a 5 per cent contraction; and indicators such as fiscal balance, current account, savings and investment rates are also down. In particular, the global external environment, including the recovery prospects in advanced economies, is vastly different.

Over time, it will be known whether the V-shaped recovery of the rupee represents a new regime of higher currency flexibility. The changing patterns of currency deployment to achieve the following objectives offers insight to the central bank’s changing beliefs.

First, the objective of maximising growth can occur through augmenting the pool of available capital via the finance channel, or by affecting the direct component of aggregate demand: India’s net exports. The weight assigned to the former suggests that the foreign savings route is superior. Contrastingly, the evidence suggests that the foreign savings-growth relationship is, at best, nebulous, with recent studies showing a negative association. Further, history abounds with instances of exports as a driver of growth. Thus, it is little wonder that there is serious advocacy of dollar depreciation to help the US economy recover.

The second objective is exchange rate-based stabilisation. Between October, 2009 and April, 2010 Real Effective Exchange Rate appreciation has accelerated by an average of 2 per cent per month, alongside increasing inflation and capital inflows. In the not too-distant past (2007-08), the RBI had considered this channel to be fairly ineffective. Its estimated pass-through showed that a 10 per cent appreciation lowered Wholesale Price Index (WPI) inflation by 1.1-1.3 per cent; this would be lower in a slowdown as the exchange rate pass-through to prices weakens when demand conditions are soft and the exchange rate environment is volatile.

Lastly, in an environment of tightening liquidity, there is a preference for exchange rate-based stabilisation over increased interest rate defence and higher cash reserve requirements. The exit roll-out and resolute speak of the RBI in October had the markets braced for a 25 basis points cash reserve ratio (CRR) hike in November and December, 2009, followed by a CRR-come-interest rate hike in January, 2010. The CRR increase materialised in January, and the interest rate defence in March. The response to appreciation has been less discernable, yet still comprehensive over the same period. The macroeconomic conditions are a key determinant of the decision-making process.

In short, the central bank’s motives are not easily determined. The concern is that over the medium term, an excessive reliance on growth from foreign capital could obscure export competitiveness. It may also skew the industrial structure towards non-tradeable goods geared to the domestic market and sheltered from foreign competition. This is not a desirable outcome for India at this stage of development.

Perhaps, these currency responses in time of crisis serve multiple objectives, such as attracting foreign capital, offsetting negative confidence shifts triggered by rating agencies’ downgrades, and providing low-cost funds to firms facing high domestic lending rates. This will be known soon, as capital inflows continue to surge.

Renu Kohli was, until recently, with the International Monetary Fund.

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