Jaimini Bhagwati: Is the rupee correctly priced? - II

We need to review concessional yen loans, which were contracted 10-15 years ago and still have 10-20 years left to mature

The domestic price of the Indian rupee (INR) was discussed in the first part, and this second instalment deals with the external price of the INR. Spot and forward exchange rates reflect the current and future external prices of the INR vis-à-vis other currencies. The soundness of the price discovery process embedded in observed exchange rates can be gauged from whether currency swap markets between the INR and major international reserve currencies, e.g. the dollar, euro, pound sterling, and yen are liquid and extend to long maturities. The supporting logic is that long-term currency swap markets enable market participants to lock in correspondingly long maturity forward exchange contracts.

A necessary, although by no means sufficient, condition for large-volume, long-term INR currency swap markets to develop is the extent to which the INR is fully convertible on current and capital accounts. Consequently, it could be maintained that for a better market determination of INR exchange rates, the INR should be convertible. This article will insist that this would be premature. And for now, incremental improvements could be made using the Government of India (GoI) and State Government Public Debt Offices (PDOs), which were proposed in the first part of this article for sovereign liability management. In any case, there cannot be a fully free market in currencies of sovereign nations since national priorities necessarily take precedence. All references to exchange/interest rates in this article are to nominal rates. However, the arguments developed are equally valid for real exchange/interest rates.

For two convertible currencies, forward exchange rates reflect interest rate differentials between the currencies. That is, the forward exchange rate for the higher interest rate currency would depreciate just enough to neutralise the interest rate difference. Occasionally, there are fleeting opportunities when forward rates do not fully neutralise interest rate differentials. At such times, arbitrageurs get into the act and forward exchange rates quickly adjust to eliminate the possibility of riskless profits.

The INR is convertible on the current account but not fully on the capital account. It follows that currency-swap markets between the INR and convertible currencies, e.g. INR-US$ are limited in volume and maturity (usually not more than $150 million per swap transaction with maturities often not beyond five years). Consequently, it could be maintained that INR exchange rates vis-à-vis the major international reserve currencies do not reflect the "true" external price of the rupee.

Looking back in time""has there ever been a "true" external price for any currency? The "beggar thy neighbour" mercantilist trade policies of promoting exports and suppressing imports were periodically prevalent between the 16th and the 19th centuries. Similar export promotion policies resurfaced in the form of competitive devaluations in the depression years of the 1930s. The "fixed" exchange rate system set up post 1945 under the aegis of the International Monetary Fund required member countries to peg their currencies to the US dollar and the dollar was convertible to gold. This system unravelled in 1971 as dollar holdings around the world reached such high levels that the United States could no longer guarantee conversion of dollars into gold. Since 1971 the so-called freely floating system of exchange rates (within bands for certain currency pairs) has often been breached when central banks have intervened to buy or sell their national currencies.

The dangers that stem from premature capital account convertibility can be well illustrated with the example of the Russian GKO (GKO is an abbreviation for short-term Russian government bonds) crisis in 1998. Non-residents were allowed entry to the GKO market in 1996 and by 1998 held almost 30 per cent of the outstanding stock of GKOs. This amounted to about $25 billion when foreign exchange reserves stood at about $16 billion at the end of July 1998. The cost of debt service surged as interest rates were raised to defend the rouble and restrict capital outflows. Nevertheless, there was substantial capital flight and in 1998 Russia defaulted on rouble-denominated public debt.

Again in 1998, during the Asian currency crisis Malaysia imposed capital controls and was less adversely affected as compared to Indonesia, South Korea, and Thailand, which had more liberal capital controls. China and India, with prudent external debt policies and non-convertible capital accounts, were even less affected.

There are occasional suggestions, even from those who are sceptical about freely floating exchange rates, that a convertible INR would inhibit lax fiscal policy. Given our narrow tax base and the relatively large stock of sovereign domestic plus total external liabilities, which together amounted to about 79.5 per cent of GDP as of end March 2005, INR convertibility could easily become a recipe for a balance of payments crisis. We need to first improve the domestic pricing of the INR, which cannot be done without relieving fiscal stress, before we move any closer to capital account convertibility.

Since capital account convertibility is not a feasible option for now what are the other steps that could be taken towards a more market-determined external price of the INR? In the first part of this article it was suggested that PDOs, which would be at "arm's length" from the RBI, the GoI, and state governments, could be entrusted with the management of sovereign and state government liabilities. The GoI-PDO could also be responsible for external debt management. Such a GoI-PDO could facilitate sovereign debt issuance in hard currencies. The interest rates that correspond to the GoI's hard currency bond prices in active secondary market trading could be used to derive forward INR exchange rates. We would thus obtain market indications of the external prices of the INR without INR convertibility. A spin-off benefit would be easier convertible currency bond issuance by lower credit rated sub-national borrowers.

Additionally, the GoI-PDO could review the trade-offs related to retaining/prepaying individual loans out of the stock of sovereign borrowings from bilateral or multilateral sources. For instance, we need to review concessional yen loans, which were contracted 10-15 years ago and still have 10-20 years left to mature. The fixed interest rates at which these loans were contracted are considerably above current market rates and the GoI would reduce debt-servicing costs if it were to refinance these borrowings at current rates even from commercial sources. To summarise, as the PDOs build up expertise these could perform a valuable "treasury" function for the GoI and state governments.

j.bhagwati@gmail.com