The recent depreciation episode has been a costly shock for both the financial and the real economy. The large and abrupt drop in the currency’s value – in the absence of a meaningful intervention by the central bank – has negatively impacted businesses and households by pushing up costs in an inflationary phase; increased price uncertainty and volatility in an already tough environment; dented economic confidence; and worsened the critical macroeconomic aggregates, thereby tilting a delicate economic balance into a downward slide. The near free-fall of the rupee and its disastrous fallout raises an important issue of public policy: is it worth keeping intervention as an additional tool at our disposal?
There is little doubt that intervention is no longer a policy option with the central bank: this is apparent from the end of intervention-cum-reserves’ accumulation as one of the responses to manage foreign capital inflows from 2009 onwards; in the instant round, the Reserve Bank of India’s (RBI’s) belated and feeble intervention – after several reiterations of its non-interventionist stance that reportedly led speculators to short the rupee and exacerbated the currency’s fall – is telling.
Yet the current experience offers an opportunity to take a critical look at the trade-offs from macroeconomic policy choices in recent years.(Click here for table)
In 2010-11, capital inflows were buoyant, aggregating $60 billion net, with an underlying gross exposure of $932 billion (column 2 of the table). Net intervention by RBI in the year was $1.7 billion and the stock of international reserves remained unchanged from 2007-08 levels mostly due to revaluation. The exchange rate adjusted fully to this inflow with a nominal appreciation of an average four per cent year-on-year each month; the adjustment in real effective terms was double this — an average monthly rate of 7.8 per cent year-on-year.
The year 2010-11 was also a time of very high inflation that averaged 10 per cent monthly. Crude oil prices rebounded 32 per cent; fuel prices rose an average 12.3 per cent each month while food price inflation averaged 16 per cent monthly. Both oil and non-oil imports grew briskly at an average 20 per cent every month.
With nearly 80 per cent of oil supplies from abroad, there’s little doubt about the role a stronger currency might have played in restraining imported inflation. Exchange rate appreciation also allowed authorities to lessen the weight assigned to interest rates for monetary tightening that domestic inflationary conditions demanded. Indeed, policy rates remained deeply negative – 3.15-4.65 percentage points lower than the average inflation rate of 9.9 per cent – throughout the year.
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A hands-off exchange rate policy was helpful on other counts as well. What, for example, might have been the fiscal cost of intervention in an inflationary phase?
This cost arises from the exchange of foreign currency purchases for rupee assets (called Market Stabilisation Bonds or MSBs) by RBI to limit the feedback into domestic money supply; so the need to neutralise the expansionary impact of foreign inflows is greater when monetary conditions have to be kept tight or consistent with the monetary policy stance. Because rupee interest rates are higher relative to foreign currency, the differential interest cost devolves onto the government balance sheet, adding to the existing interest burden and worsening the fiscal position.
Assuming RBI had bought half the net capital inflow in 2010-11 – $30 billion – and fully offset the impact on money supply, MSBs of approximately Rs 1.37 trillion would have had to be issued (column 4; notes 3 and 4 of the table). This issue would have been in addition to the budgeted market borrowings for 2010-11 — Rs 3.45 trillion. The fiscal cost of this intervention, viz the interest bill for the additional issue of MSBs of Rs 1.37 trillion, works out to approximately Rs 62.47 billion (column 4 of the table); this is 0.13 per cent of GDP and 2.6 per cent of the total interest payments of the central government in 2010-11.
How much pressure would have come on the yield rate? That’s hard to predict, but it is doubtful if a bond supply of nearly Rs 4.8 trillion – that is, Rs 1.37 trillion of MSBs plus Rs 3.45 trillion of budgeted borrowings – would have resulted in an average long-bond yield rate of 7.9 per cent as it did in 2010-11. Illustratively, this was the average yield in 2007-08, when inflation averaged 4.8 per cent and total bond issues aggregated Rs 1.34 trillion (government borrowings of Rs 1.3 trillion and MSB issues of Rs 1.02 trillion, column 1). The current year, 2011-12, can serve as a rough guide in this regard: expected borrowings of more than Rs 5 trillion (budgeted plus unscheduled) pushed bond yields beyond 8.75 per cent in November (note 2 and column 3 of the table), forcing the government to lift caps for foreign investments in sovereign bonds, examine other means of disinvesting to reduce the bond overload and RBI to regularly manage yields through open market operations. There’s little doubt, therefore, that a no-intervention policy, by avoiding sterilisation bill issues, averted pressure on the yield rate in 2010-11, helping keep borrowing costs low for the government as well.
The wheels of fortune turn, however. Forward to 2011-12 and the sharp fall in currency value following the reversal of foreign capital. Column 3 of the table computes the expected fiscal damages from this shock: fuel subsidy bill is likely to expand to Rs 1 trillion (budgeted Rs 236 billion) due to higher fuel costs from the rupee depreciation; revenue losses from fuel tax cuts are another Rs 490 billion; while the additional interest cost of unscheduled market borrowings to fund the budgetary gap is another Rs 100 billion. Further, this extra expenditure – nearly Rs 1.6 trillion – comes at higher borrowing costs that averaged 8.5 per cent until November 2011.
Apart from the fiscal damages, the unrestrained fall of the rupee has pushed up domestic inflation, which is of “serious concern” to RBI, trying to control it from 2009. Harder to quantify are the injuries to the private sector – a sudden and large increase in external repayment obligations; shelved investment spending due to difficulties in raising additional financing and extreme price volatility; firms’ market valuations and so on – but the contribution of this devastation towards an aggregate build-up of a downward spiral and the negative impact on growth is easy to observe.
Against this outcome in 2011-12, was it worth incurring a fiscal cost of Rs 63 billion in 2010-11 to keep intervention as an additional policy tool for use when the wind blows the other way?
An extra firepower of some $30 billion, accumulated when capital inflows were strong, may have facilitated early and decisive intervention to mitigate the unanticipated shock of capital flows’ reversal in 2011-12. Moreover, the pressure on yields in 2010-11 could have been reduced by adjusting the nearly Rs 1.48 trillion gathered as 3G auction revenues and spent in over-generous subsidies – for example, diesel subsidy of Rs 384 billion alone – in 2010-11 against budgeted borrowings to accommodate MSB issuance. This would have translated into a stronger fiscal position in 2011-12. In conjunction with a stronger reserves’ position, this would have provided greater policy room to maneuver unanticipated shocks.
As with any macro story, this one, too, can be told differently. But since all trade-offs represent conscious policy choices, it is a fair question whether the hands-off exchange rate policy was a deliberate one to check imported inflation? If so, what lessons have we learnt?
The author is a macroeconomist based at ICRIER, New Delhi; she is a former staff member of the International Monetary Fund and the Reserve Bank of India.