In the absence of RBI intervention, the exchange rate is likely to be far more volatile.
As the new Governor settles down, he has a daunting agenda ahead of him: the first probably is to narrow the divergence between Mumbai and Delhi. It is no secret that there were differences on issues like interest and exchange rate policies, capital flows, etc. This apart, the central bank has major challenges in terms of inflation control, exchange rate policy, capital account liberalisation, and the banking system. Some perspectives on the first two in this article.
Monetary policy and growth
Inflation remains at an unacceptably high level and, clearly, there will be pressures to bring it down at least before the general election. Dr Subbarao has said that he would give priority to anchoring inflationary expectations: on the other hand, there are an increasing number of agnostics on the topic of moulding inflation expectations and the impact this can have on prices. A few weeks back, I had quoted Dr Bernanke’s doubts on the issue (World Money, July 28, 2008). Another critic argued that “managing expectations cannot alter economic fundamentals” and that “depicting expectations as a determinant of inflation violates fundamental notions of economics” (Christopher Lingle, Centre for Civil Society, New Delhi, Mint, September 9).
Advocates of monetary tightening often argue that there is no contradiction, in the long run, between growth and low inflation. On the other hand, it is futile to argue that, in the near term, monetary policy can bring down inflation without hurting growth and consumption, whatever the jargon used (“cooling down the overheated economy”, etc). And, in his first press conference as Governor, Dr Subbarao seemed to acknowledge this (“we will be mindful of the implications of our monetary stance on the growth prospects”; Business Standard, September 10). Interestingly, even the Governor of the Bank of England, in his letter to the Chancellor dated June 16 about the inflation situation, argued that “if Bank Rate were set to bring inflation back to the (2 per cent) target ... there would be unnecessary volatility (that is, fall) in output and employment”. Clearly, central bank autonomy and a single-point agenda of inflation control are not sufficient to ignore output and employment issues! UNCTAD recently cautioned that “measures to tighten monetary policy would exacerbate the global slowdown” and that there is a “risk of anti-inflationary overkill”. And, growth does seem to be slowing in India as the Q1 data suggest. But, a fall in global commodity prices, particularly oil, does create more room for a less hawkish central bank.
“Manipulating” the exchange rate
Critics of managing the exchange rate use the term “manipulating” to describe the process: this “manipulation” is supposed to be to subsidise exporters. (Given a likely merchandise trade deficit of the order of $125 bn in the current year, it seems that the manipulated exchange rate seems to be subsidising importers rather than exporters!). Is the central bank “manipulating” the domestic value of the rupee, by trying to bring inflation down? There is a temptation to look at any intervention in the market as a sin. The problem with this argument is that the ability of the markets to overshoot fundamental values and remain at those levels is much stronger than the ability of those dependent on market prices to remain solvent, as Keynes said a long time back. More recently, Paul De Grauw (FT, September 5), while criticising the European Central Bank for allowing the euro’s wild appreciation, argued that “[t]he ECB was influenced by a theory that says that prices always reflect economic fundamentals. In this view it is both undesirable and futile to fight market forces, which are always right.” (In reality, markets are rarely paragons of informed rationality.) Such arguments apart, managed exchange rates have a strong pedigree even in liberal economies, right from Bretton Woods to the 1980s’ Plaza and other agreements. More recently, in March, the US, EU and Japan had planned joint intervention to arrest the plummeting dollar. Raghuram Rajan (FT, August 20) advised emerging markets to “shift from (globally) traded goods to non-traded goods” and reach “regional agreements to appreciate collectively”. This is nothing but managing, or, if you prefer, “manipulating” the exchange rate.
Other critics point to the cost of holding excess reserves, which is a corollary of the exchange rate policy. There are easily calculable costs to central bank intervention in the currency market when the resultant money supply is sterilised. What is often forgotten is that the cost of non-intervention could be much larger through lost output and growth, on the one hand, or inflation, on the other, but not quite so easy to calculate. I recently read a study titled “Cost of Holding Excess Reserves: The Indian Experience” by Abhijit Sen Gupta of ICRIER (March 2008). The conclusion is that, “India is losing more than 2 per cent of its GDP by accumulating reserves instead of employing resources to increase the physical capital of the economy.”
One wonders to what extent the following questions have been considered while arriving at the conclusions. If the RBI had not intervened and allowed the rupee to appreciate even more, several questions arise:
There are no simple answers to these questions but they can hardly be ignored. One thing is clear: in the absence of intervention, the exchange rate is likely to be far more volatile, increasing the risk of cross-border trade and investment. To that extent, a volatile and erratically moving exchange rate, “overshooting” on both sides, would be an impediment to fuller globalisation of the economy — to my mind, it primarily benefits only the currency traders. And, the value of that to the broader economy is dubious.
One needed change in the exchange rate policy is greater transparency: that the RBI intervenes merely to control volatility is a myth.
