Ajay Shah: The buck should stop somewhere

Stability is obtained when central banks are prevented from meddling in either the currency market or in capital flows.

The Thai Baht has been one of the more interesting currencies of the world. Prior to the Asian Crisis, it was a de facto pegged exchange rate. From 1985 onwards, there was a "market", but the government ensured that there were no significant price movements. By "containing volatility", the government gave the private sector false expectations about currency risk.

In the 1997 crisis, in a few days, the currency moved from 22-25 THB per dollar to a low of 55 per dollar. This large movement generated bankruptcy on a massive scale among corporations and banks which had dollar-denominated borrowing, and had been persuaded by their government that the umbrella of public sector risk management would do its job.

Owing to this period, the Thais understood that a de facto pegged exchange rate is bad policy. In the post-2000 period, the standard deviation of weekly percentage changes in the rupee-dollar (INR/USD) exchange rate was 0.44%. The comparable number for Thailand was 0.78%. The Thais have much superior currency flexibility.

Things got awkward this year in Thailand, when the coup of September 19 appears to have actually helped break a damaging political stalemate. It has given an improved outlook on the Thai economy, and generated a surge of capital coming into the country. The Baht has risen about 16% this year, to a nine-year high. That is a big move""e.g. it would be an appreciation of the Indian rupee from 45 to 38.

Faced with strong lobbying by exporters who are hurt by appreciation, the Thais faced a difficult situation. The menu of options is short, and all the options are unpleasant.

The central bank can do manipulation on the currency market. But this is difficult, and distorts monetary policy. The Thais remember how badly this had failed in 1997.

The central bank could cut interest rates to deter capital flows. But the short-term profit from currency appreciation is large. Even if the interest rate goes to zero, thus igniting inflation, it might not stop capital inflow.

The central bank could introduce capital controls. But capital controls are deeply distortionary. An entire bureaucratic apparatus is created to watch over the movements of capital, and give out permits to some. The political economy of quantitative restrictions is deeply corrosive, as is well-known from the field of trade, where there is now a consensus that all QRs must be abolished.

In Indian policy circles, these three approaches (market manipulation, interest rate changes, and capital controls) are considered normal and acceptable. Thailand has a better appreciation of the flaws of these paths when compared with India.

There is a fourth approach, which was invented by Chile. Faced with a surge of capital coming in, the Chileans had a principled position that in a rational approach to economic policy, there was no place for capital controls. As a person from their central bank once said to me, "We are Chile; we don't do capital controls". There was a quest for a market-based solution, which changed the incentives of foreign investors, but yet did not involve a licence-permit raj.

The Chilean idea was to enforce putting a fraction of the capital inflow in non-interest bearing accounts with the central bank which are locked in for a year. Apart from this, there was full convertibility. The government played no role in trying to constrain the foreign investor in any fashion""they were free to buy or sell shares or bonds or real estate, etc.

A similar approach was implemented by the Thais on Monday. Banks have been required to lock up 30% of new foreign currency deposits for a year. Through this, foreign investors have to effectively have a horizon of more than a year in order to justify coming in.

This approach is attractive, particularly when compared with the problems of the other three approaches of market manipulation, interest rate changes or capital controls. It must be emphasised that this "tax" on capital inflow should not be seen as an additional element of capital controls. The sensible strategy is to eliminate all capital controls, and only have this "tax". This would eliminate the licence-permit raj, avoid the microeconomic distortions of capital controls, and avoid a corrosive political economy, while still trying to keep the government in the game of influencing the exchange rate.

Does it work? The evidence is weak. In the case of Chile, the authorities tried this for a short while, but then realised that it did not particularly help matters, and they went on to have true convertibility. In the case of Thailand, the Monday announcement induced jitters on the part of the private sector, and was associated with a big drop in stock prices and in the Baht. The investor has seen Thailand have a coup on September 19""this makes it difficult to have confidence in the long-term performance of the country. These events in Thailand have had reverberations all over the world, including the 2.5% drop in stock prices in India on Tuesday.

The history of currency arrangements is riven with war stories of this nature, where governments trying to have a say on exchange rates have run afoul of one problem after another.

For this reason, the modern consensus is that there is only one stable solution. This involves (a) a floating exchange rate where the government is a spectator on the currency market, just as it is a spectator in price formation in other financial and real-sector markets; (b) an open capital account where no licence-permit raj interferes with the movement of capital across the boundary and (c) an inflation-target which anchors domestic fiat money to the basket of commodities that is used to making the CPI. These three elements are internally consistent and constitute a stable, long-term solution to the monetary policy puzzle. Other arrangements incur microeconomic distortions, an opportunity cost in terms of lowered growth, and lurching from crisis to crisis.

Central banks like to say that they care about systemic stability or financial stability. But their actions reveal a lack of interest in stability; flawed thinking by central banks has induced numerous crises. The modern understanding is that stability is obtained when central banks are tied down by inflation targeting, and prevented from meddling in either the currency market or in capital flows.