Given the impact of the exchange rate on all aspects of the economy, it would be unwise to leave it to market forces.
As argued in last week’s column, the crisis in financial markets over 2007-08 and the post-crisis analysis, have raised serious questions about the efficiency of markets in bringing about rational outcomes. I had summarised the issues of financial theory discussed in the Turner Report published by UK’s Financial Services Authority (FSA) in March 2009. Apart from this, there is now a general consensus that monetary policy cannot ignore asset prices. To quote from the RBI governor’s JRD Tata Memorial Lecture in Delhi recently, “The monetary stance of studied indifference to asset price inflation stemmed from the now notoriously famous Greenspan orthodoxy … (Its) surmise was that the cost-benefit calculus of a more activist monetary stance of ‘leaning against the wind’ was clearly negative. It is more cost effective for monetary policy to wait for the bubble to burst and clean up afterwards rather than prick the bubble in advance.”
“The Great Unravelling has, however, shattered the intellectual consensus around both inflation targeting and the Greenspan orthodoxy on asset price build up. The crisis has made two things clear … the policy of benign neglect of asset price build up has failed.”
The two asset classes customarily considered with regard to this issue are equity and real estate. While these are important, to my mind, in terms of the financial markets, there is one other asset class which is perhaps of even greater importance, particularly to a developing economy like that of India — that is foreign currency. The price in question is, of course, the exchange rate. At first sight, it may sound odd to consider foreign currencies as an ‘asset class’ whose price should now be ignored by monetary policy. But the fact is that in the floating rate era, currencies have been ‘commoditised’ with their price fluctuating minute to minute. Besides, the exchange rate affects the economics of a very large part of the transactions in an economy. In our case, the ratio of our gross external transactions (current flows plus capital flows) to the GDP has grown to 112 per cent. Many domestic transactions also take place at import parity prices — and are, therefore, influenced by the exchange rate. While discussing the volatile price of oil in an article in the The Wall Street Journal, Prime Minister Gordon Brown and President Nicolas Sarkozy had argued that, “such erratic price movement in one of the world’s most crucial commodities is a growing cause for alarm. Volatility and opacity are the enemies of growth”. Surely, volatility in, and the prevalence of exchange rates not properly reflecting economic fundamentals, are equally damaging to investment, growth and employment, particularly in developing economies?
It is interesting in this connection to look at the history of floating exchange rates. The international monetary system put in place at the end of the Second World War envisaged an IMF-administered fixed exchange rate regime. This gave a great fillip to global trade and growth for the next 25 years. The system collapsed when the US unilaterally suspended the convertibility of the dollar into gold in August 1971. Thereafter, there were attempts to bring back fixed exchange rates (notably the Smithsonian Agreement of December 1971), but these did not work after the oil price shocks of 1973, and also because, by then, most of the developed economies had liberalised capital flows. In other words, floating exchange rates were not the result of a deliberate policy.
Subsequently, beginning with the Thatcher-Reagan laissez faire economic philosophy, belief grew in the invisible hand of the market also being the infallible hand; in other words, market-fundamentalism became fashionable. Exchange rates amongst the convertible currencies came to be dominated by capital flows, often of a speculative nature, rather than economic fundamentals. The result was extreme volatility in the major currencies’ exchange rates, Capital flows have also become important to the rupee’s exchange rate. As the Governor argued in his Tata Memorial Lecture, “Finally, we need to manage the monetary fall-out of volatile capital flows that queer the pitch for a single focus monetary policy. A boom-bust pattern of capital flows can lead to large disorderly movements in exchange rates rendering both inflation-targeting and financial stability vulnerable. Like other emerging economies, India too will have to navigate the impossible trinity as best as it can.” To my mind, even ‘orderly’ movements in the exchange rate, continued for a time, can be destabilising — just consider the impact of an ‘orderly’, unidirectional change of 10 paise per dollar per day (admittedly an extreme example), continued for a year: It could mean closure of many domestic industries and huge unemployment if it is in the direction of appreciating the rupee, or inflationary and leading to defaults on foreign currency obligations, if it is in the other direction.
It is in this background that one needs to consider Dr Rajan’s suggestion in his lecture, that the RBI should ‘focus’ (not ‘target’, whatever the difference) on inflation, intervene in the exchange market only at the time of extreme volatility, and ignore the grumbling of exporters. Is the issue that simple?