I was disappointed with the contents of the Financial Stability Report released by the Reserve Bank of India in so far as the comments on the exchange rate are concerned. Most of the crises in the developing/emerging markets during the last two decades have had their root in the appreciation of the exchange rate in real terms. This was the case in Mexico (1994-95), east Asia (1997-98), Brazil (1998), Argentina (2002) and, more recently, several east and central European countries and Iceland. In most of these cases, the common features were:
Given this history, as far as financial stability in India is concerned, one would have liked a deeper analysis of the issues involved and why policymakers believe that we need not be concerned. In the February conference hosted by RBI, Deputy Governor Shyamala Gopinath explicitly acknowledged that “Capital flows are a risk ... also for financial stability” (Business Standard, February 13). Yet, there is only a passing reference to the issue in paragraph 22 of the “Overview and Assessment”.
In constructing the financial stress indicator (FSI) in the Indian context, the report has used two variables — namely exchange market pressure (EMP), and the volatility of the dollar-rupee exchange rate. One has questions about the use of both. As for EMP, defined as “the sum of exchange rate depreciation and reserve outflows (scaled by base money)”, it “summarises the flow excess supply of money in a managed exchange rate regime (emphasis mine).” Does the use of this variable imply that we manage the exchange rate? The RBI has always been very coy in admitting this, saying that it intervenes only to curb volatility. Exchange rate volatility is an accepted measure of market risk. However, one is not convinced of its use as a measure of the exchange rate risk to financial stability. In my view, the latter arises from the level, as distinct from volatility of the exchange rate, and its reflection in the real effective exchange rate and the current account balance. To take an extreme example, if the dollar depreciates 10 paisa every day for a year, volatility of the exchange rate change is zero. On the other hand, a dollar-rupee rate of Rs 20 in a year’s time would surely cause a major crisis: indeed, a crisis would occur well before that level is reached.
And, in our case, the rate is reaching worrying levels. The FSB discussion of the exchange rate (paragraph 4.14) starts with the rate in October 2007. To my mind, a more reasonable starting point should be March 2007, i.e., before RBI suspended intervention. Since then, in terms of the RBI’s real effective exchange rate (REER) index, supplemented by my estimates, the rupee has appreciated by 9 per cent over the next three years and 25 per cent in the last 12 months alone! This appreciation would surely start widening the trade deficit (10 per cent of GDP) and current account deficit of 6-7 per cent of GDP, net of remittances: the latter are more in the nature of irrevocable capital transfers, though accounting convention classifies them in the current account. Complacency about the exchange rate because of the easy financeability of the true deficit through inward remittances and other capital flows is not only not conducive to growth but can also be risky.
On the issue of managing the exchange rate in the face of capital inflows, the RBI Governor has described the dilemma as follows: “If central banks do not intervene in the foreign exchange market, they incur the cost of currency appreciation unrelated to fundamentals. If they intervene in the forex market to prevent appreciation, they will have additional systemic liquidity and potential inflationary pressures to contend with. If they sterilise the resultant liquidity, they run the risk of pushing up interest rates, which will hurt growth prospects.” While it is good to see an explicit acknowledgement that higher interest rates hurt growth, and while one agrees with the first two points, the third one about the rise in interest rates is debatable. In fact, if sterilisation is limited to rupees pumped in the market by intervention, liquidity and hence interest rates should remain where they were before the intervention. In other words, sterilisation by itself does not lead to a rise in interest rates from levels existing before the intervention.
