Looking at sterilisation costs alone incorrectly assumes that non-intervention has no costs.
Last Monday, I had argued the need for managing the level of the exchange rate — and not just the volatility. In India’s case, to my mind, the issue is all the more important in the context of the free trade agreements being signed, and also given the deficit on the current account. As calculated conventionally, the deficit was 2.6 per cent of GDP in 2008-09. However, these calculations include remittances as part of invisibles. While this is the accounting convention, in substance, remittances are more like capital transfers rather than revenue earnings: They have little to do with the competitiveness of the domestic economy in the global context. Net of the remittances, our current account deficit was as high as 6.5 per cent of GDP in 2008-09. In other words, compared to a relatively balanced current account (again net of remittances), we are losing output worth up to Rs 350,000 crores, with correspondingly lower creation of gainful employment for many millions.
Last week, I had discussed the risks and costs of a freely floating exchange rate for the economy. To be sure, there are actual (or potential) costs to managing the exchange rate as well. There are two ways for a central bank to influence the exchange rate:
Clearly, the first affects the real economy. Higher domestic interest rates to attract foreign capital (by making foreign currency borrowings more attractive for residents, for example) to support the domestic currency obviously makes capital costlier for most borrowers, and is deflationary. Sales or purchases of dollars in the market also affect the money supply directly and interest rates indirectly. The impact can, of course, be neutralised (‘sterilised’) by open market operations (sale or purchase of government securities in the market). But this can be costly: If domestic interest rates are higher than foreign currency interest rates, buying dollars (adding to money supply) and selling domestic securities (to mop up the excess supply) reduce the central bank’s income by replacing (higher yielding) domestic securities by (lower yielding) foreign currency assets. This cost is easy to calculate even on the back of an envelope and critics of managing exchange rates cite this as an argument against intervention. But there are many counter arguments.
There also are costless ways of sterilising the money supply — by increasing the banking system’s cash reserves with the central bank, for example. Many consider this to be a tax on the banking system, a proposition with which I disagree. If the extra money supply created by central bank’s purchases of dollars, which would otherwise not have been there at all, is impounded by the central bank through higher interest free reserves, it should leave the resources and earnings of the banking system as a whole unchanged.
Apart from this, looking at sterilisation costs alone assumes that non-intervention (and hence non-sterilisation) — allowing the exchange rate to go where it will — has no costs: There are, albeit not calculable on the back of an envelope. If a currency appreciates, the impact on the real economy is deflationary — this means investment, employment and growth will fall compared to the levels they otherwise would have been at. So will government revenues.
It is time that we abandoned the myth of a rational market: Even the arch believer, Alan Greenspan, in his testimony to the US Congress in October 2008, confessed that he watched with “shocked disbelief” as the “whole intellectual edifice collapsed in the summer (of 2007)”. In his JRD Tata Memorial Speech, the RBI Governor said that “the financial sector has no standing of its own; it derives its strength and resilience from the real economy. It is the real sector that should drive the financial sector, not the other way round”. Well said, sir! To my mind, one contribution the financial sector can make to the real economy is to aim at an exchange rate which will ensure you have current account (net of remittances) which is in near balance. In India’s case, this would help reduce the Rs 350,000 crore output gap I discussed in the beginning.
The problem of managing exchange rates and sterilising the impact on money supply becomes more difficult under a liberal capital account. It is well accepted by now that a managed exchange rate, an independent monetary policy and a liberal capital account cannot co-exist. In his Tata Memorial Lecture, the Governor said, “Finally, we need to manage the monetary fall-out of volatile capital flows that queer the pitch for a single focus monetary policy. A boom-bust pattern of capital flows can lead to large disorderly movements in exchange rates rendering both inflation targeting and financial stability vulnerable. Like other emerging economies, India too will have to navigate the impossible trinity as best as it can.” More on this next week.
