A V Rajwade has argued well for giving up a liberal capital account (“Exchange rate policy - II”, May 3). There is, however, one misconception that needs to be corrected. He says: “ …it is possible to manage the exchange rate even in a relatively liberal capital account regime, by intervention in the exchange market and sterilisation of the impact on money supply through open market operations or changes in the reserve ratio of the banking system.” There is enough evidence to show that sterilisation has almost no effect on the exchange rate.
A sterilised intervention through the open market operations leaves the money supply unchanged and has no direct way of affecting interest rates or the expected future exchange rate. If there is any effect, it is by way of signalling the future course of monetary policy that may influence the demand for domestic assets and future exchange rate. (See The Economics of Money, Banking and Financial Markets by Frederic Mishkin). This is why central banks in the West and Japan gave up market intervention long ago. The Indian experience also shows how sterilised intervention has had no lasting effect on the exchange rate.
A Seshan, on email
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