<b>A V Rajwade:</b> Financial stability, capital flows and rupee

Research say fast growing economies have relied on domestic savings to finance domestic investments

Given the general anti-globalisation stance of the US President-elect, and the negative portfolio capital flows to India in the last few months, one was hoping for some analysis of the issue in the Reserve Bank’s Financial Stability Report published last month: there was little beyond innocuous comments, recounting some numbers. Nor has the new governor said much on the subject beyond repeating the usual mantra of “intervention for curbing volatility, no targeted level”. His two predecessors seem to have used the exchange rate policy more as an anti-inflationary measure than to optimise growth, output and employment creation. The latest six-country real effective exchange rate (REER) index, at 126, is not very different from what it was when he took charge and suggests continued, significant over-valuation. The question is whether this level is optimum for the macroeconomic objectives of growth and employment, or even financial stability.

I recently came across two interesting observations on the issue of exchange rates. One was an article in this paper (December 23) by two Hong Kong economists, who argued that “when the dollar is weak, multinationals borrow in dollars to finance their business in emerging markets, which yield higher returns in local currency”. But how does a weak dollar, in other words stronger local currencies, lead to “higher exports and growing capital inflows” from/in emerging economies, as they believe?

A recent paper by two economists in the Bank for International Settlements, “Does the financial channel of exchange rate offset the trade channel?” (BIS Quarterly Review, December 2016), argues, “An appreciation of the local currency can strengthen the balance sheets of domestic borrowers in foreign currency, easing domestic financial conditions. This ‘financial channel’ of exchange rates can act as a potential offset to the trade channel, in that an exchange rate appreciation boosts domestic economic activity through easier financial conditions. Conversely, a depreciation could negatively affect the economy by weakening domestic balance sheets. ...an appreciation can stimulate the economy through the transfer of net wealth from foreign currency savers to borrowers.” The economists have used the usual mathematical models to “prove” their extremely questionable conclusions, which, strangely enough, are based on the nominal, not real, exchange rate. The other side is that most Asian economies — from Japan in the post-war period to China in the last 30 years — grew rapidly on undervalued exchange rates pushing up exports. Again, most research suggests that fast growing economies have relied on domestic savings to finance domestic investments, not foreign currency borrowings.

Coming back to India, as per the latest balance of payments statement, in the first half of the current fiscal year the trade deficit was of the order of $50 billion, partly financed by net services export of $32 billion. The current account number at 0.6 per cent of the GDP looks benign, but this is after accounting for a very large “secondary income”, principally remittances which are not earnings of our economy. Meanwhile, the International Investment Position as on September 30, 2016, shows liabilities in excess of assets of as much as $370 billion; net of foreign direct investment, both inward and outward, the deficit is still $200 billion, and financed by portfolio investment of  $230 billion. To my mind, the “record” level of reserves will find it difficult to cope with portfolio capital flight, which could be triggered by continued uncertainties on the tax front, and the overall global situation. The finance minister recently called for “globally competitive tax rates”; the State Bank of India chairman believes that import duty protection is necessary for domestic industry to prosper (Indian Express, January 8). Perhaps what is needed even more is a globally competitive exchange rate with the objective of balancing the external account, net of secondary income, in a few years which will not only help growth and employment, but also mitigate the vulnerabilities on stock account. (The “Minsky moments” are by definition unpredictable!)

In his Weekend Ruminations last Saturday, T N Ninan had argued that “a more lax fiscal stance (in the forthcoming budget) will be viewed negatively by international investors”. The other side is that, in the US, the President-elect’s plans to increase public investment in infrastructure, and cut taxes, both of which will lead to higher fiscal deficits, has triggered a sharp rise in the dollar (and the stock market), signifying that investors (or should we call them speculators?) like Mr Trump’s economic policy stance on the fisc! To be sure, I have lost faith in the rationality of market participants’ behaviour a long time back!

The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwade@gmail.com