The RBI reduced intervention to conserve reserves in a time of great uncertainty. There was a shift from a fear of floating, to a fear of depleting reserves. This was unnecessary as capital inflows resumed quickly, with the Indian recovery adding to reserves once more.
In the absence of central bank intervention, changes in the exchange rate on account of capital flows were often contrary to the requirements of macro-stabilisation. Capital responded to external events. And, often, capital flows were sentiment-driven, and unrelated to fundamentals.
The RBI exchange rate policy is affecting prices. In 2007, an appreciating exchange rate helped keep inflation low although oil and food prices were firming up internationally. But outflows began just as cost shocks rose sharply.
A steep depreciation in May 2008 contributed to the WPI peak in August. The supply shocks turned out to be temporary, as oil prices crashed in September, so avoiding depreciation could have softened inflation. Instead, policy rates were raised sharply to control inflation. Industrial growth collapsed.
In 2010 as inflows revived, appreciation occurred before export growth had recovered, and this worked against the macroeconomic stimulus. The CPI, which had peaked during the crisis, finally fell in February, but outflows due to the Greek crisis depreciated the exchange rate, and both the WPI and CPI rose again.
Generally, a nominal appreciation prevents inflation from setting in after a temporary supply shock. Real appreciation, however, reduces export competitiveness. This effect cannot be ignored when the trade deficit in India is so large.
Is it time for a more flexible exchange rate policy?
Full capital account convertibility and a full float at the present juncture would be fundamentally unsound. But the middle ground between a fix and a float is large. Earlier, the chief concern was to limit appreciation from inflows, given the trade deficit. So, a short-term nominal depreciation maintained the long-term real exchange rate at a fixed level. But with two-way nominal variation, more objectives can be accommodated. Since temporary supply shocks occur so often, the exchange rate’s potential to reverse their effects on inflation should be noted. Exchange rate changes to commodity prices is rapid and will rise given greater deregulation of petroleum prices and the closer link of food prices to international prices. In general, the exchange rate channel of monetary policy transmission has the shortest lag.
The past two years have demonstrated the impact of the interest rate on aggregate demand. A more flexible exchange rate supports a counter-cyclical interest rate. An appreciation reduces export demand but reduced intermediate import prices support domestic demand.
Furthermore, non-price factors are important for exports. So, if there is a conflict, the inflation effect of the nominal exchange rate must be given precedence over its demand effect. Multiple policy instruments can be aligned to give markets a clear signal.
Convergence of the CPI with WPI inflation is slow, partly because food and oil price shocks have a very different impact on each. Engineered policy shocks to the exchange rate can aid convergence. The government lost considerable goodwill because of sustained inflation and the absence of effective supply-side measures to tackle it. Tax-tariff cuts are other short-run possibilities, though it is not wise to neglect any available instrument.
Some exchange rate flexibility deepens the market and encourages hedging, but excessive change hurts the real sector. So, there should be limits to exchange rate flexibility. Despite considerable development, foreign exchange markets continue to be thin. Large foreign capital movements can cause excessive exchange rate fluctuations.
If a central bank does not buy or sell a currency that is not freely traded internationally, sharp spikes occur. Swings beyond plus or minus 5 per cent invite excessive entry of uninformed traders. But below that level, speculative one-way bets on the exchange rate rise since the risk in such bets falls. So a 10 per cent band is the volatility level a managed float should aim at.
Ashima Goyal is Professor of Economics at the Indira Gandhi Institute of Development Research, Mumbai.
A version of this article originally appeared here on Business Line.