Over the weekend, Indians were told that the Centre planned some big changes for Monday, Pranab Mukherjee’s last full day as finance minister and the first working day after Prime Minister Manmohan Singh returned from a series of global summits. Expectations were ramped up, considerably, with the prime minister promising action on reform. Mr Mukherjee said, specifically, that measures would be announced to halt the slide of the rupee; India’s currency has depreciated beyond what most analysts would suppose is the exchange rate that economic fundamentals suggest. In response, markets saw some excitement. Stock exchange indices rose, and the rupee appreciated by a percentage point against the dollar. But when Monday rolled around, the news was disappointing: the Reserve Bank of India (RBI) stopped at liberalising foreign exchange regulations marginally. The rupee lost most of the gains it had made, and market indices closed at the day’s low. The government lost even more credibility; and showed, once again, that it was incapable of the expectations management that is so crucial to a modern economy.
The RBI’s new regulations, which it released in consultation with the Centre, have allowed companies in the manufacturing and infrastructure sectors with foreign exchange earnings to borrow in dollars to cover rupee loans, up to a ceiling of $10 billion, as long as the borrowing is claimed to be for capital expenditure. In addition, it has very slightly eased the cap on foreign investment in government bonds from $15 billion to $20 billion, as well as expanding the set of foreign investors eligible to invest in Indian government securities to include sovereign wealth funds and pension funds. Some incentives were also announced for qualified foreign investors in infrastructure mutual funds. While the drift of these reforms is praiseworthy, because they are intended to improve capital inflows to bridge the current account deficit, they are far too small in scope and ambition. For example, demand has been much higher than supply for government securities, and the $15 billion limit is usually exhausted quickly; there was scope to raise the cap much higher. Foreign investment in rupee-denominated government bonds should have been opened up much further — it reduces the cost of government borrowing, opens up domestic funds for the private sector, and acts as an automatic stabiliser on the currency, given the stability of investor expectations regarding government debt. On the other hand, the measures also increase India Inc’s exposure to foreign debt in an increasingly uncertain global economic environment. Unsurprisingly, markets were disappointed that the government failed to come out with a more credible and robust package of actions to tackle the rupee slide.
Managing a floating currency in 21st-century foreign exchange markets requires an understanding of how investors form expectations, and how those expectations can create rigidities and pressures that allow the currency to drift away from fundamentals. If most market participants expect the rupee to appreciate to 60 for a dollar, it will do so — unless the government does something radical to alter expectations. What it must not do is set up expectations, and then disappoint them; but that is what it has consistently done over the past year. The limited and marginal nature of the reform the government delivered on Monday does not augur well for the power and utility of the remaining reform agenda that the prime minister has promised is on its way.