A V Rajwade: The exchange rate debate

As the rupee continues to remain strong, the debate about the exchange rate is hotting up. Hardly a day passes without the pink and, increasingly, even the white newspapers carrying an article or interview on the subject. The interest is of course natural given the fact that, over the years, an increasingly large percentage of the economic activity in the country is being accounted for by external transactions. The prices of many domestic transactions are also governed by the exchange rate.

Govindraj Ethiraj expressed surprise in an article in this paper (May 15) as to how exporters were "so unprepared for something basic like currency fluctuation". While I agree with the point made to some extent, the limitations of the argument should also be kept in view. Firstly, hedging against adverse currency fluctuations has some regulatory restrictions and is, therefore, at best, a short-term solution. In any case, hedging can protect against a further worsening of the present rate, but has no solution to an existing, uneconomic rate. But hedging apart, what else can the average exporter do? All his costs are going up "" power, wages, most commodity prices and so on. One solution is to import raw material rather than purchase it from domestic suppliers. The attraction of imports over the domestic supplies is of course the result of an overvalued currency and those who support continued appreciation or a free float, should really ponder whether a fast increasing merchandise trade deficit (see World Money, April 30, 2007) is really something in our interest at a time when we need to create a crore-plus jobs every year. Surely there is something wrong when, despite all our comparative advantages in producing textiles, it is necessary to import them today from China to remain in the garment export business "" China, incidentally, imports cotton to make them.

The term "Dutch disease" was first coined to describe overvalued currencies, arising from the high prices of a commodity which a country exports. (At one time, the Netherlands faced the problem after huge offshore natural gas discoveries, and hence the name). Our problem arises not from a surplus on current account, but capital inflows, and is perhaps more comparable to Mexico and east Asia in the mid-'90s, and not to the Dutch disease: overvalued currencies sustained on capital inflows, increasing current deficits, until one day, the music stops.

Some economists, of course, question whether the rupee is at all overvalued; question the accuracy of REER as a measure of competitiveness given its base year, composition, and changes in the economy "" such criticism is equally applicable to any index, the WPI, for instance. But this apart, the huge and growing deficit on current account, net of remittances, is itself proof of the currency's overvaluation "" we do not need measures accurate up to four decimals to come to this judgement.

In his article in this paper (May 14), Prof Vivek Moorthy finds it incongruent that even while expressing concern about the seriously overvalued rupee, I have criticised RBI's moves to reduce capital inflows. Not being an economist, I tend to look at these issues from the yardstick of promoting investment, growth and employment. From this perspective, I have criticised both the RBI's discomfort with credit growth and its anxiety to reduce inflows, when the economy cries out for investment in infrastructure and industry.

For the same objectives, I do believe that it is in our interest to have an undervalued exchange rate as long as most of our exports are not in "differentiated products" valued for their variety and range, and not prices. Can this objective be feasible in the face of capital flows? To me, the short answer to the question is, yes. A legitimate issue is the cost of intervention in the market and sterilisation of the resultant money supply. To the extent this is done through the market stabilisation scheme securities, there is a cost to the exchequer "" in today's conditions this could be quantified at around Rs 2,500 crore per annum on the current MSS ceiling of Rs 1,10,000 crore. In any case, the cost of non-intervention and the resultant overvalued exchange rate, are much higher in lost output, lower profitability and revenues "" but not so easy to calculate.

This apart, to my mind, MSS is not really needed for sterilisation which can be more easily and costlessly achieved through an increase in CRR. Prima facie, banks lose on CRR deposits, and the use of CRR for sterilisation, therefore, is a tax on the banking system (see the article by Arvind Subramanian in this paper, May 22). However, the argument misses out on one fact: the resources being impounded through higher CRR would not be there, but for the intervention. Therefore, intervention accompanied by an increase in CRR to the extent needed for the sterilisation of resultant money supply, leaves the banking system's economics unchanged: the RBI is putting money in the pockets of the banks through one window (intervention) and taking it away through another window (increased CRR).

avrajwade@gmail.com