Abheek Barua: Why is the RBI intervening again?

If the RBI were to support the country's configuration of growth, the supply of money would have to grow.

Much of the recent debate on RBI intervention versus a hands-off policy in the foreign exchange market has focused primarily on the competitiveness of the rupee. Those in favour of heavier intervention have claimed that a continuously appreciating rupee would compromise export growth and eat into aggregate growth rates. Thus if the current growth momentum has to sustain, policies have to be put in place to correct the appreciation.

Those in favour of the hands-off strategy have broadly followed two sets of arguments. For one, they have argued that with increasing capital mobility, intervention in the capital market followed by sterilisation (issuing bonds to mop up the liquidity that's created) is somewhat futile. The process of sterilisation pushes up domestic interest rates and thus attracts more capital flows, which again prop up the exchange rate. The second strand of their argument is that if the right index or set of indices are used, the rupee might not be that overvalued at all relative to its peers.

There is perhaps some truth in the fact that the simple five-country real effective exchange rate overstates the extent of overvaluation. Depending on which base year is chosen, the index reveals an overvaluation of 10-16 per cent. But is it really the right index to choose in gauging export competitiveness? The Bank of International Settlements (BIS) publishes REER indices each month. Using 2000 as the base year and consumer price indices as weights, the Bank computes REERs for as many as 52 economies. This can help to compare the loss of competitiveness across peer economies.

India surprisingly doesn't fare too badly on this score-sheet. Using these indices, India's exchange rate has moved up in real terms by about 6.7 per cent in the period between June 2006 and April 2007. In the same period China's REER went up by 4.5 per cent, Thailand's by a little over 7 per cent and so on. The point is simple""we have certainly lost competitiveness in an absolute sense but so have our competitors. Thus, in relative terms we might not be that badly off after all.

If indeed sterilisation is self-defeating and competitiveness hasn't really gone for a toss, why then has the RBI resumed intervention in the foreign exchange market? Going by foreign exchange reserves data, the RBI bought close to $3.5 bn over the past week, putting an end to the relentless northward march of the rupee. The answer to this can perhaps be found by looking beyond the competitiveness and sterilisation debate.

First, the central bank needs to add to the supply of money to support the demand for money that stems from economic growth. If GDP were to grow by about 8.5 per cent in 2007-08 and inflation averages about 5 per cent, it would entail growth in money demand by 17-17.5 per cent. If the RBI were to support this configuration of growth and price increase, then the supply of money would have to grow correspondingly.

The supply of money increases as a result of the interaction of an increase in reserves (or base money) and the money multiplier. A critical component of reserve money is the net foreign exchange asset (NFA) position of the RBI or simply foreign exchange reserves. On June 1 (the latest data available), for instance, outstanding NFAs equalled about 112 per cent of outstanding reserve money. The money multiplier determines the relationship between each unit of base money and final money supply. For the uninitiated, the money multiplier bears an inverse relationship with the cash reserve ratio (CRR).

What does all this have to do with intervention in the foreign exchange market? To cut a long story short, the RBI needs to buy dollars to meet its reserve money target, which in turn would enable it to meet its money supply target. How short is it today? Under the assumption of an unchanged money multiplier, it needs to add about Rs 114,000 crore of reserve money over 2007-08. Until last week, it had added about Rs 43,000 crore, which leaves a deficit of about Rs 71,000 crore.

A significant portion of this will have to come through growth in foreign exchange reserves. Back-of-the-envelope calculations show that the RBI needs to grow its foreign exchange reserves by about $18 bn over the year. Until June 1, reserves grew by $9 billion. That means that the RBI might need to buy another $9 billion of reserves over the year if it meets its money supply target. The timing of these purchases is for the RBI to decide. However, it is sensible to assume that the RBI would buy dollars when dollar inflows are strong and there is pressure on the rupee to appreciate. Thus, purely from the perspective of supporting monetary growth, there is likely to be dollar-buying by the central bank. This would tend to break the dollar's free fall against the rupee.

The other motivation for the RBI to intervene stems for its profit and loss account. Since the RBI has a rupee balance sheet and holds foreign currency reserves, any rise in the rupee's value against foreign currencies entails a valuation loss that the RBI books in its Currency and Gold Revaluation Account (CGRA). Although there are no direct monetary ramifications of this loss, it does weaken the balance sheet of the central bank. In an extreme situation where losses keep mounting, the central bank needs to turn to the exchequer for recapitalisation. The implication is that the central bank might find it imperative to cap rupee gains to limit these losses. My estimates show that between June 2006 and May 2007, these losses added up to about Rs 50,000 crore. Reason enough to try and prevent further appreciation?