Ajay Shah: The middle muddle

The RBI has failed to display intellectual leadership in correctly understanding India as an open economy.

In recent months, many claims have been made about exchange rates and macro policy, which are incompatible with the empirical evidence. What appears to be going on is the breakdown of the closed economy worldview. New thinking is required to match the new India.

It is claimed that India has suffered a terrible 20 per cent appreciation from Rs 49 a dollar in June 2002 to Rs 39 a dollar today. It seems obvious to most people that such an INR appreciation is completely inappropriate.

However, we need to look deeper at what was going on. Over the same period, the USD has been losing ground, as part of the adjustments required for narrowing the massive US current account deficit. Going by the US Fed's "nominal major currencies index", the USD lost 29.43% over this same period. Going by the "nominal broad dollar index", the USD lost 20.43% over this same period.

We in India are so used to running a pegged exchange rate to the USD that we assume that an INR appreciation against the USD is an appreciation. But if the USD is dropping and we try to hang on to a nominal value of the USD, then we are trying to force a depreciation of the INR. The appreciation as seen in the REER is very small (roughly 10%) when compared with that seen in the INR/USD rate.

It is claimed that INR appreciation would have a terrible impact on exports. However, the empirical evidence does not square up.

Suppose we focus on June 2002, when the rupee peaked at Rs 49 to the dollar. In the 63 months that led up to June 2002, exports growth in dollars averaged 6.97%. In the 63 months after this date, exports growth averaged 23.88%. While the REER appreciated after June 2002, monthly exports of merchandise tripled over these five years. Any simple claims about the impact of exchange rate fluctuations on exports are not compatible with the evidence.

It is claimed that corporate profitability would be squeezed as firms struggle to maintain export competitiveness. A sharp rupee appreciation took place from March 15 to April 6. Hence, the April-June quarter was the first one in which firms faced a strong rupee. In this quarter, the corporate sector's profit after tax grew by 38.43%. Early indicators for the July-September quarter suggest 30% growth in profit after tax. Profitability is at unprecedented levels.

It is claimed that a middle path will work, that the old policy framework will get the job done if only government will comply with the RBI's policy positions.

A few months ago, a drumbeat was built up about external commercial borrowing (ECB). Every friend of the RBI demanded restrictions on ECB. It was claimed that a middle path is required, with a little unsterilised intervention plus a little capital control on ECB plus a little fiscal cost on MSS.
This was tried. It did not work.

These mistakes have costs. We suffered the fiscal cost of a bigger market stabilisation scheme, the economic inefficiency of constraining firms on ECB, and the loss of credibility that goes with rolling back reforms on ECB. Most importantly, we are suffering from an inflation process that is increasingly out of control. CPI-IW inflation "" the best measure of inflation in India "" has accelerated from 6.72% in January to 7.26% in August. Getting CPI-IW inflation back to 3% is the most important macroeconomic challenge India faces today, and the sum total of policy efforts in 2007 has failed to get the job done.

This is not unexpected, given the expansionary stance of monetary policy. Interest rates at the short end are roughly 7%, and CPI-IW inflation is also at roughly 7%. The stance of monetary policy is: a real rate of zero at the short end of the yield curve. With a real rate of zero, it is not surprising that we have a boom in asset prices and accelerating inflation. Bringing inflation back under check requires the short end of the yield curve be at least 3 per cent in real terms.

Now the drumbeat is building up about private equity flows and participatory notes. Before policy makers accede to these requests, the track record of the RBI on thinking about economic policy needs to be re-evaluated. There appears to be a gap between the closed economy worldview and the new India, an India that is highly globalised and has new behavioural patterns. The policy reflexes that used to work in the mid-1990s do not work today.

It has long been clear that there is an incompatibility between the new globalised India and the present monetary policy framework. The right way to resolve this incompatibility is to reform the monetary policy framework. India's globalisation, which feeds into India's growth, is more important than the protection of the RBI in its present form.

So far, there has been little progress on RBI reforms. What we are seeing, instead, is a campaign that, step by step, seeks to put India back into the straitjacket of capital controls. The Budget this year brought the denial of tax passthrough for private equity funds unless they were investing in a stated list of industries. Then came the barriers against ECB. Now comes the advocacy of restrictions on PNs and private equity flows. It appears that step by step, focused policy lobbying is taking place on one element of capital account reform, to obtain a reversal of reforms on one element at a time.

I believe this strategy will not succeed. India has come too far along in terms of globalisation. The political economy of capital account decontrol has slipped out of the RBI's hands. With foreign investors supplying $200 billion of capital to Indian firms, there is no possibility of a large turnabout on the capital account opening that made this funding possible. The reversal of reforms on the capital account is as unfeasible as a project as bringing back high Customs duties.

There is no escape for macro policy other than to confront the realities of a large capital account with increasing de facto convertibility. In most countries, central banks have played a leadership role in putting monetary policy on a sound foundation. In India, unfortunately, the RBI has failed to display intellectual leadership in correctly understanding India as an open economy, and supporting the transformation of the RBI that is required to achieve sound monetary policy.