Shankar Acharya: Too little, too late?

A PIECE OF MY MIND

Some six months ago (BS, April 26, 2007) I criticised "the authorities" (MinFin and RBI) for the abrupt shift in India's exchange rate policy in March 2007, which entailed a fairly sharp appreciation of the rupee. It's time to revisit the issue and assess developments over the past six months. But before doing so, let me reiterate a couple of key points made in my April piece, which seems to have eluded some participants in the debate.

First, the sharp horns of the trilemma posed by the textbook "Impossible Trinity" (simultaneous attainment of exchange rate stability, monetary independence and capital account convertibility) are substantially blunted for India by the presence of partial capital controls. This allows us to retain significant autonomy over both monetary policy and exchange rate management. It is tiresome to have the trilemma argument trotted out repeatedly by commentators who should know better. Second, contrary to popular belief, the substantial appreciation of the rupee in recent times (see figure) is not just a problem for exporters. It's also a problem for all other domestic producers of tradable goods and services, who face cheaper import competition. More broadly, the available evidence indicates that exchange rate appreciation poses a significant threat to growth of output and employment (see Surjit Bhalla, BS, August 18, 2007).

Turning to post-April developments, there is both good news and bad news. Leading with the latter, there has been a predictable slowdown in export growth of goods and services, with rupee earnings stagnant or even negative in some labour-intensive sub-sectors such as textiles and leather products. While the foreign trade data do not show this, there is increasing reportage in the pink papers of labour-intensive manufacturers for the domestic market struggling to survive, retrenching or even closing in the face of cheaper import competition. Given the usual lags between orders and sales, these adverse costs of rupee appreciation are likely to mount.

On the positive side, the backlash to the pre-May rupee appreciation seems to have elicited some desirable corrections in official policy along the lines recommended in my April article (no causation claimed!). The RBI's tools for countering the continuing surge in foreign capital inflow, which is the underlying pressure for appreciation, have been strengthened by augmenting the size of the Market Stabilisation Scheme (MSS). The RBI has used this instrument (together with CRR increases and LAF operations) to bolster its purchases of the incoming foreign exchange and "sterilise" their liquidity consequences. Thus, forex reserves rose by a hefty $62 billion between April 1 and late October this year. Second, the MinFin moved, at last, in early August to reverse its earlier policy error of premature (and untimely) liberalisation of external commercial borrowing (ECB) policy, which led to the massive surge in ECB net inflows to over $16 billion in 2006-07, followed by another $7 billion in the first quarter of the current year (for more on this, see my piece in BS, August 9, 2007). Last fortnight, SEBI has acted, under MinFin guidance, to tighten the guidelines for participatory notes (P-notes) and other offshore derivatives on Indian shares. In this context, the finance minister has clearly acknowledged on television the need to "moderate foreign capital inflows" and has opined that the currently elevated rupee exchange rate was above the government's "comfort zone".

As a result of all this, especially the RBI's dogged and sustained intervention in the forex market, the 6-currency real effective exchange rate (REER) index of the rupee has stabilised around 115 (1993-04=100 base) since May and even the bilateral Rs/$ rate has not appreciated significantly beyond the 40.8 level of May 2007 (see figure). And this has been accomplished despite the recent upswing in capital inflows (especially FII investments) after the US Fed's loosening of monetary policy in September and the ensuing surge of equity flows to premium emerging markets.

Good as they may seem, these results are far from adequate. An REER index level 11-12 per cent higher than in summer 2006 is much above the "comfort zone" for healthy and sustained growth of tradable goods and services and employment in them. And the struggle to hold the line seems to be getting harder. As several analysts have noted, surging foreign capital inflows and rising forex reserves are not a uniquely Indian phenomenon. China and a number of other emerging market countries have confronted similar challenges. Yet, their exchange rate appreciation over the past year is typically less than the rupee's. This begs the obvious question about the effectiveness of India's policies in this domain. Has it all been a case of too little too late? Certainly that's the impression one gets when it comes to "moderating" ECB and FII inflows.

So what is to be done? First, the MSS limits need to be swiftly augmented to empower the RBI to move much more aggressively to purchase forex and sterilise the counterpart rupees. The goal should be to bring down the REER index to the order of 110, preferably lower. Second, the belated steps taken by MinFin on August 7 to tighten ECB policy should be implemented faithfully, without too many special "exceptions". Third, the recent tightening of guidelines on P-notes may need to be revisited with a view to mandating swifter unwinding of P-notes. Fourth, the grant of ad hoc fiscal "sops" to exporters to compensate them for rupee appreciation should be discontinued. Aside from being arbitrary, untidy and fiscally unsound, such sops only compensate a sub-set of the producers hurt by appreciation. More importantly, they distract from the correct policy, which is to reverse much of the recent appreciation. Fifth, there should be a systematic and coordinated (between MinFin and RBI) review of available options to deal with the special challenges posed by the unprecedented surge in foreign capital inflows into the country.

If all this, sounds too heterodox and "market unfriendly", then buckle up for the turbulence on the alternative, "market knows best" trajectory: the rupee continues to appreciate to 35/$ (or 30?) within a year; exports and import-competing activities become increasingly uncompetitive; the trade deficit widens further to well above the 7 per cent of GDP of 2006-07 and service exports nosedive; retrenchments proliferate and unemployment increases; economic growth flags; foreign investors lose confidence, take fright and seek to exit; the exchange rate plummets; and we are back to Rs 50/$ (or 60?) after having laid waste to large swathes of the productive economy, not to mention bankrupting the financial system. Sounds unlikely? Don't be too sure. Stupid policies can beget some pretty bad outcomes. That's the lesson of economic history, including our own. Oh yes, and there may be some political consequences as well.

The author is Honorary Professor at ICRIER and former Chief Economic Adviser to the Government of India. The views expressed are personal