Why exchange rate volatility is essential for economic flexibility

While some people view exchange rate fluctuation as detrimental to the economy, it is, in fact, a crucial element of economic flexibility

In a recent interaction with the public, the leadership of the Reserve Bank of India (RBI) spoke with some pride about the exchange rate stability of the past couple of years. Is this actually a matter to be proud of? In the language of the computer revolution, is this a feature or a bug? First, let’s examine the facts.

The top graph (Rupee-dollar dynamics) shows a flat patch, where the USD/INR exchange rate stopped moving much. The bottom graph shows a longer historical perspective. The last time a similar flat patch was found in history was around 2006. After a long history of government control of the exchange rate, India took a big step forward to becoming a market-oriented economy, with the decontrol of the exchange rate. Now, we are back to de-facto government control of an important price in the economy.

Why did the thinkers of the 1991-2011 period shift from a government-controlled rate to a market-determined rate, one that fluctuates from day to day? The first element of this is just the basic logic of the market economy. Supply and demand play out in the market every day and they make a price. Prices are not the subject of policy decisions. To take a simple example, let us say the demand for pencils goes up for some reason. In the short term, the price of pencils will go up so that the market can clear. That is, the quantity supplied matches the quantity demanded. In the medium to long term, there will be a supply response and price will move, settling somewhere between the initial price and the increased price caused by the shortage of pencils.

Volatility and price fluctuations are the essence of the price mechanism. There is no sensible way in which an official can determine the correct price; only the market knows the answer. A large user of pencils, perhaps an art studio, may not like price fluctuations. They can manage their own private risk better by entering into fixed price contracts, for which they would, of course, pay a premium to remove the risk.

The philosophy of Indian socialism was that price fluctuations are a bad thing and that the coercive power of the state should be used to keep prices fixed. Officials would choose what the price of pencils should be. They would declare that pencils are an “essential commodity” (EC) and mandate by law that the price cannot fluctuate. Those who buy and sell pencils at prices above the controlled rate would be violating the law and thus be liable. Law sometimes — as the EC Act did — criminalises this and these people can be jailed for their “crimes.”

In the eyes of those with a certain level of economics knowledge, this approach looks attractive, as there is less volatility and the world is a more pleasant place for everyone. This is an illusory gain as the main method of organising the economy is fluctuating prices. The world will change, suppliers and demanders have to change, and the price system synchronises all their adjustments. The essence of  an economy is the distributed process involving millions of people, who look at changed prices and decipher their own optimal reactions, all of which feed back into modified prices.

This reasoning equally applies with the exchange rate. In good times, more capital comes into India, and the exchange rate should appreciate. In bad times, less capital comes into India, and the exchange rate should depreciate, which is good for exporters and tradable firms. Policymaking in India graduated out of price controls across many areas, such as cement, steel, and the exchange rate. There are at least five tangible arguments about why the exchange rate should be determined by the market and not by policymakers:

1. The flexible exchange rate is a natural shock absorber. In good times, the rupee appreciates, which crimps the economy and vice versa. This stabilises the macroeconomy.

2. How is an official to choose the correct exchange rate? This is an analytically and politically difficult question. Officials no longer choose the price of cement. We can ask a monetary policy committee (MPC) to choose the short rate based on an inflation target. There is no way to bring a group of experts to choose the correct exchange rate.

3. A fixed exchange rate constitutes free risk management for private persons, as they don’t have to do their own currency risk management. It is hard to argue that such a government subsidy mechanism is justified.

4. Moral hazard. When the private sector is coddled like this, they will take on more currency risk, and these things generally come to grief. (Exposed private people will also do more lobbying for policies that are good for their positions).

5. The impossible trinity. It is better for India to have an open capital account, to build a sophisticated bond-currency-derivatives (BCD) nexus, with an inflation target. With all this, the concomitant is that the exchange rate has to float. The contradictions associated with the inflation target and the controlled exchange rate are the deeper explanation behind policymakers harming currency derivatives trading, imposing a tax collected at source (TCS) on outflows, etc.

This kind of reasoning was in play from 1991 to 2006, and the debates ended with the shift towards exchange rate flexibility alongside the development of currency derivatives markets that support the risk management of private persons. The RBI appears to have made major decisions in reversing this policy strategy, closing down the working of some parts of the currency derivatives markets, and going back to a near-fixed exchange rate. Such major decisions need to be backed by public debate and rationale. Economic policy is best done when it is grounded in intellectual discourse. This is how economics worked in the successful decades. As an example, inflation targeting did not emerge out of thin air, it was the end of a 20-year journey of research and intellectual debate on what was the wise solution for India’s objectives.

The author is an honorary senior fellow at the Isaac Centre for Public Policy, and a former civil servant