Intervention, sterilisation and volatility

WORLD MONEY

In last week's article ("Currency intervention and MSS", March 8), I had argued that there are financial and economic costs to non-intervention in the currency market, and that these could well be far larger than the costs of sterilisation that critics of the Reserve Bank of India's (RBI's) policy have emphasised.

On the subject, I had cited Ila Patnaik's article "Feeding an elephant" (February 18). Another article by Patnaik, "Dining with the devil" (March 3) focuses on the same theme. Patnaik argues that "It is not clear that lower currency volatility is particularly better."

One had thought that the point of price volatility adding to risks was settled long ago with the modern portfolio theory, one of the basic tenets of which is that price volatility, as measured by the standard deviation of price changes, is the measure of risk inherent to exposure to that price.

Clearly, for importers and exporters of goods and services, and those undertaking cross-border investments, volatility of the exchange rate increases the risks of globalisation. And the availability of hedging tools is no panacea.

A study published by the National Bureau of Economic Research some time ago had concluded that reduced exchange rate volatility significantly increases trade, and that a common currency has an even more potent effect.

So who benefits from volatile exchange rates? Clearly, the trader or speculator in currency markets. Indeed, there would be no speculation without price volatility.

About 95 per cent of the currency exchanges among the three major currencies "" the dollar, euro and yen "" consist of speculative trading.

Nobel Laureate Robert Mundell wrote some time ago, "What economic function did the exchange rate changes among these islands of stability fulfil? Except for stuffing the socks of hedge funds, the answer is none."

The conceptual objection to central bank intervention in the exchange market flows from the rather touching belief that it is economic fundamentals that determine the market price; and that any adulteration of market parity, any attempt to influence the price is a sin.

(This shows how far we have come. In the 1950s and 1960s, state intervention could do no wrong; over the past couple of decades, at least for some analysts, state intervention can never be right. Perhaps, both views are equally wrong.)

But how far is this belief founded in reality? Take a recent case when the euro moved from over $ 1.28 to less than $ 1.22 in a matter of 10 working days. What was the change in economic fundamentals warranting a 5 per cent change in the exchange rate in such a short time?

While any number of illustrations could be cited, space constraint limits me to the most egregious. In autumn 1998, the yen:dollar exchange rate moved from ¥ 146 to ¥ 111 in a matter of six weeks.

The reason was the collapse of the Long Term Capital Management (LTCM) hedge fund, and hence, of the so-called "carry trade" in the yen:dollar market. The yen was weakening, the hedge funds were borrowing yen at low interest rates, buying dollars, and investing in dollar bonds.

This was profitable so long as the yen kept weakening "" indeed, the trade helped weaken the yen by shorting it, thus, making it a self-fulfiling prophecy. Whom did the carry trade benefit?

None others than those pinpointed by Mundell. But LTCM collapsed, and with it the yen carry trade. Should this be glorified as an "economic fundamental" justifying the 30 per cent change in the exchange rate?

In fact, one of the features of today's exchange market is that there aren't too many followers of economic fundamentals left. A huge majority consists of trend followers and it is they who determine prices.

As former Bundesbank President Ernst Welteke wrote, "It seems that they do not focus on those variables that they would, acting in isolation, believe to be most relevant for the valuation of a currency. Rather, they concentrate on variables that they believe other analysts will focus on."

Keynes had always suspected the solvency of those who believe in the ability of markets to price assets correctly, when he argued that "the market can remain irrational longer than you can remain solvent".

Let me turn to some other points made by Patnaik. She argues that "pegged currency regimes are innately vulnerable to speculation" and criticises "RBI's original sin of pegging to the dollar". One does not know, of course, what she means by the alleged "peg" to the dollar.

In common parlance, a peg would mean an unchanged nominal exchange rate. This clearly is not the case "" if anything, the object of intervention seems to be to keep the exchange rate relatively stable in real effective terms.

True, currency pegs have proved disastrous when they led to overvaluation and consequent unsustainable deficits on the current account: Mexico in 1994-95, Thailand in 1997 and Argentina in 2001. But this is hardly the case with the rupee's exchange rate "" in fact, intervention avoids the overvaluation.

Another point made is that, because of sterilisation, "short-term interest rate remains high". One assumes that Patnaik is not arguing in favour of unsterilised intervention. Indeed, she is against intervention itself.

If so, one cannot see how the interest rates are higher than what they would have been in the absence of both intervention and sterilisation, because the two together leave the liquidity unchanged. In any case, practically all deposit rates and indeed, even long-term bond yields are negative in real terms. A sign of high interest rates?

avrco@vsnl.com