| What is the nature of India's exchange rate policy? What are some of its past successes? Why is the policy now under threat? What should be done? Read on for answers. |
| After the step devaluations of June 1991 and the phased transition to a "market-determined, unified exchange rate" by March 1993, the RBI (with MoF support) has followed a policy of "managed flexibility" within a system of partial capital account controls. In practice, this has meant fairly active RBI intervention in forex markets to moderate market-driven volatility and maintain a "competitive" exchange rate. The latter has meant using the 1993/94 value of the 6 (earlier 5) currency, trade-weighted, real effective exchange rate (REER) index as a benchmark or informal guidepost (not a formal target). |
| In the jargon of open economy macroeconomics this system has clearly been an "intermediate" exchange rate regime, falling between full flexibility (or pure float) and a fixed-rate regime (achieved through monetary union or a currency board). The combination of managed flexibility and partial capital account controls has allowed India to resolve, to a large extent, the trilemma of the famed "Impossible Trinity", which disallows the simultaneous achievement of exchange rate stability, monetary independence and capital market integration (see figure). Any two of these goals may be attained (at the vertices of the triangle) but never all three. With the help of partial capital controls India has successfully enjoyed substantial monetary independence and a fair degree of exchange rate flexibility. In practice, it has certainly helped that all three RBI governors of the past 15 years and most finance ministers (and their relevant mandarins) have mastered the nature of the system and its potentialities and pitfalls. |
| The economic merits of India's exchange rate system have been demonstrated repeatedly. For example, during the inward foreign capital surge of 1993-95, despite textbook IMF advice to the contrary, we successfully resisted nominal appreciation of the rupee and built up forex reserves, thus nurturing the nascent export boom of the period and pre-empting increased protectionist resistance to the ongoing programme of customs tariff reductions. Again, during the Asian (and later the Russian) financial crisis of 1997-98, downward (but managed) flexibility of the exchange rate was crucial (together with tight rein on short-term external debt, capital controls on residents and some monetary tightening) in warding off any serious contagion effects. Over the entire period, judicious and flexible management of the exchange rate system has played a critical role in helping India to increase significantly her share in global exports of both goods and services and tripling the ratio of current external receipts to GDP from 8 per cent in 1990/91 to 24 per cent in 2005/6. |
| If the system has worked so well, what explains the recent oddity of sharp nominal and real appreciation of the rupee, which has seen the 6-currency REER index (1993/4=100) rise from 101 in the summer of 2006 to 112 in mid-April 2007 to the consternation of exporters and many others? Frankly, it is both puzzling and distressing. Amongst possible reasons are the following. First, perhaps the recent foreign capital surge (at a time of rising inflation) has overwhelmed the RBI's capacity for "sterilization" of purchased reserves through the market stabilisation scheme (MSS) and other instruments and thus weakened its willingness to buy forex (since unsterilised forex purchases would augment liquidity and fuel inflation). Second, the finance ministry (and RBI?) may be giving undue weight to a recently fashionable (and simplistic) view that appreciation of the rupee helps contain inflation. Actually, in India, it has modest impact at high cost in terms of industrial competitiveness, exports, growth and employment, especially when India's giant Asian competitor, China, with 7 times the value of our exports, follows a sticky exchange rate policy. Third, the recent puzzling rupee appreciation may be just another symptom of weak coordination between RBI and MoF that has been distressingly evident in recent times. |
| Whatever the reason, it's high time the recent appreciation was reversed and the time-tested policy restored before serious, lasting damage is inflicted on exports, growth and employment. If this requires augmenting RBI's capacity for sterilised intervention through the MSS or other means, so be it. (The quasi-fiscal costs of this policy are well-known, manageable and far outweighed by the benefits of higher exports, growth and employment associated with a lower REER.) If it requires some tightening of constraints on external commercial borrowing by Indian corporates for domestic expenditures (to slow capital surge through this route), so be it. That might also level the playing field a bit in favour of smaller firms in the present context of tighter domestic credit conditions. To those ideologically predisposed to oppose any regulatory restraint, I should point out that successful management of intermediate exchange rate regimes generally involves some compromise with the "market knows best" principle. It's all a matter of balance. If it requires more liberalisation of capital account outflows (consistent with Tarapore II recommendations), that would also help. If it simply needs better coordination of macroeconomic policies between MoF and RBI, surely that's both desirable and possible. |
| Whatever it takes, it better be done...and done soon, if the country is to be spared the avoidable costs of an overvalued exchange rate in terms of foregone growth in exports, output and employment. |
| The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. Views expressed are personal. |
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