Jalan's farewell to foreign exchanges

The doings of the Reserve Bank are so extensively commentated upon not just because of the importance of what its Governor and Deputy Governors say but also because of the unfailing courtesy of it's Press Relations Division towards the interested public.

They have just sent Bimal Jalan's speech on 'Exchange Rate Management' where he presents to forex dealers the economic principles that have guided RBI's foreign exchange policy.

For over fifty years, India suffered a foreign exchange constraint that bedevilled all economic discussions, but finally at the end of one more crisis in Balance of Payments, Manmohan Singh initiated a change by abandoning the exchange rate.

Jalan has now consolidated that reform by ensuring such a build up of reserves that for the first time a relevant public official is able to say "the fragility of the balance of payments is no longer a concern of policy makers." (Jalan 'Exchange Rate Management' Paragraph 17).

For those of us whose working life has coincided with Manmohan and Jalan's, (Manmohan is a bit older and Jalan a bit younger than me), the very fact that we are no longer plagued by foreign exchange crises is not just a revolution but a miracle.

It should be recognised that the endless debate on whether India has paid too much for accumulating reserves pales to insignificance beside the traumatic arguments that we used to have to go through when trying to persuade the authorities to release a little bit of foreign exchange for essential spare parts.

Those who now claim that Jalan may have paid too much by way of interest, or by keeping the currency under-valued, must surely be too young to have experienced the time when India was in a permanent BOP crisis when it was not a question of what interest rate we were prepared to pay, foreign loans were just not available.

The very fact that we can now argue about such issues as the correct price of foreign exchange is simply an illustration of how far we have come.

In his speech Jalan has put forward what he believes to be a general consensus among economists on exchange rate policy. First and foremost is the abandonment of a fixed exchange rate. All developing countries have suffered in attempting to defend an over-valued exchange rate.

Second and more controversially Jalan argues that high exchange reserves are also part of the consensus, in theory it is arguable that a freely floating rate should suffice but that is consensually agreed. Everyone prefers to have adequate reserves, but the Governor has not disclosed his true reason for preferring such high reserves.

The real argument lies not in the relatively trivial economics of the question but in political attitudes. Both the general public and their representatives consider a declining currency as a sign of economic failure, particularly on the part of economic managers.

On the other hand, a rising currency is looked upon as nature's good fortune, not a sign of success in economic policy. If a currency has appreciated it is the duty of economic managers to keep it at that level.

The economic danger in this political attitude is that devaluation becomes difficult whereas maintaining under-valuation for even a sustained period of time can always be justified by our good fortune.

In these circumstances it is inevitable that skilled economic managers will prefer the accumulation of reserves and an under-valued exchange rate to a depreciating or even a fluctuating exchange rate.

In the Indian context Jalan is both an experienced and skilled manger. He understands his political masters. He has undergone criticism in the past, for loss of reserves in the pursuit of liberalisation; he understands the political character of this country.

There is therefore common sense if not economic logic in maintaining an under-valued exchange rate. Nor is it bad economics; for there is only one exchange rate policy that is disastrous for developing countries and that is maintaining an over-valued exchange rate.

Indeed those of us who have advocated capital account convertibility in the past, have done so not for enabling resident Indians to invest all over the world, but as a way of denying the authorities from sustaining an over-valued exchange rate.

That the authorities would opt for an under-valued exchange rate as a matter of policy, did not occur to those of us who have observed Indian exchange management since Independence.

On capital account convertibility, therefore, it should be said that for all intents and purposes Jalan has gone much further than campaigners for convertibility had anticipated. The rupee is as good as fully convertible, but that has been achieved not by means of a freely determined exchange rate but through a carefully managed under-valuation of the rupee.

That is a completely sustainable position for as long as the authorities are prepared to invest their acquired foreign exchange abroad.

Some economists have argued that domestic investment opportunities have been lost by the RBI's policy of maintaining an under-valued rupee. However, as the Governor points out, "The equivalent rupee resources have already been released to the recipients of foreign exchange. The decision on whether to invest, consume or deposit these additional resources lies with the recipient not the RBI."

Jalan must be right in his analysis. Economists who have argued against his line of reasoning argue that all expenditure must either be consumed or invested, that is a fundamental economic identity; that deposits are only an intermediate stage which would be invested if RBI did not provide this opportunity; but as the distinguished monetarist R G Hawtrey pointed out "Incomes and outlays are not exactly equal.

An excess of incomes over outlays may take effect in an accumulation of unsold goods." These unsold goods are defined as investment in the economic identity that makes all income equal expenditure but they cannot be described as productive investment.

It is unusual for an economic commentator to support government policies as wholeheartedly as this article suggests. There are therefore two obligatory criticisms to make. First Jalan claims that "there is strong international consensus that emerging markets should keep short-term external commercial borrowings relatively small to the total external debt" This is an absurd conclusion based on wrong premises.

India is not just an emerging country; it is, as the Governor knows, a highly sophisticated nation with great poverty. Commercial borrowing whether external or internal is simply a function of interest rates and a consequence of an under-valued exchange rate.

External commercial borrowings offer a business opportunity of a double benefit not only of a low interest rate but appreciation of the currency. RBI should not deny those who wish to speculate in that direction.

The Governor dislikes such speculative behaviour; he believes all activities in the foreign exchange market should be 'orderly' and transaction orientated. Yet that degree of control and order is not in the nature of things. The business of foreign exchange is disorderly, full of shifts and speculations.

What the authorities ought to be doing is to allow bigger fluctuations which would accustom the market to swim in deeper waters. As all the wise parents in RBI will know, a child cannot learn to swim if he is always held by his mother.

sjmulji@aol.com