Subir Gokarn: Targets & transitions

There is a minimum threshold at which the benefits of a floating currency outweigh the risks; that needs to be targeted.

The decision by the US Federal Reserve Board to cut its benchmark fed funds rate by 50 basis points last week has significantly reduced the probability of the US economy going into recession. One striking consequence of the Fed announcement was the huge upswing in Indian markets, which brought back into the spotlight a trend that has garnered a lot of attention in recent weeks "" rupee appreciation.

At less than Rs 40 to the US dollar, the rupee reached a level it had last achieved in 1998. From this level, it depreciated to its historically lowest level of about Rs 49/$ in 2002, before being put through a gradual, managed appreciation to the Rs 43-44/$ range that we had become used to seeing over the last couple of years. This process, of course, resulted in the accumulation of a large corpus of foreign exchange reserves, to a point where they began to hinder the effective execution of domestic monetary policy.

Consequently, in response to the decision by the Reserve Bank of India (RBI) to stop accumulating any further reserves, the rupee appreciated by about 10 per cent in a matter of months, the same magnitude of change it had experienced in the much longer period of five years. Not too many people complained about a 10 per cent change over five years, whereas lots of people screamed bloody murder at the appreciation between March and July 2007.

Until last week's developments, it appeared that the RBI was reverting to the managed exchange rate approach, after having allowed a 10-12 per cent appreciation to take place. Last week's surge, however, demonstrated that even this position may be untenable in a relatively stable global financial environment, in which India is among the more attractive investment destinations and looks likely to attract larger and larger capital inflows as more and more investors try not to lose out on the opportunity. If this trend continues, it will make no difference at what exchange rate appreciation is resisted. Further reserve accumulation and the monetary pressures that it exerts are inevitable.

The only sustainable exchange rate policy in this situation is a genuine float. This, in turn, can be accomplished only in an environment of full convertibility. For a market to function efficiently, all eligible participants should be able to trade without restriction; currently, the limits on outward investments by resident individuals, as generous as they may be, are a constraining factor on efficient price discovery.

But, this is easy to justify as an objective or target. What does cause concern is the speed of transition. As is quite clearly demonstrated by the contrast in the rate of rupee appreciation in the recent past, a gradual movement is quite palatable to all those who might be impacted by it, whereas a rapid adjustment of similar magnitude towards a market outcome (which, clearly, hasn't been reached yet) raises howls of protest, presumably because they have not been able to counter the effects of appreciation with offsetting increases in efficiency in the short time available.

If one accepts the inevitability of a market-determined exchange rate (whatever it may be), while also recognising that abrupt movements are disruptive and painful, finding the middle ground involves laying out a transition roadmap, which will allow us to achieve the objective in a reasonably short period of time, while also allowing affected interests to make the adjustments necessary to accommodate the change.

We do have a transition plan towards full convertibility, which visualises us achieving that state by 2011. Going by our recent experience with the increase in capital inflows, however, that is way too far into the future. However, whatever the timeframe that may be set, there are two key preconditions that need to be fulfilled. First, the financial system has to raise its levels of protection against the eventuality of sudden and sharp capital outflows. This requires both consolidation amongst sub-optimally sized institutions and sophisticated risk management systems. The latter are being steadily built up but the former is clearly not taking place at a rate that is consistent even with this very generous timeframe.

Second, the markets and instruments that investors and intermediaries need to hedge their exposures at as low a cost as possible need to be developed or, where they already exist, strengthened. Both these are processes involving continuous movement towards an end goal, which is itself constantly shifting, so they can never be deemed to be "finished". Equally, however, there is some minimum threshold at which the benefits of a floating currency outweigh the risks; it is this threshold which needs to be targeted within a timeframe that is far shorter than seven or five or even four years.

Once that threshold and the timeframe to reach it are decided upon, a transition process for the currency itself needs to be designed. Here, China again provides a precedent in terms of the mechanism, though not necessarily in terms of rate of adjustment. Two years ago, the Chinese government committed itself to an appreciation of 3 per cent per year for the yuan, which it has broadly been following. In effect, this means that the government will intervene in the market to absorb surplus foreign exchange only after that 3 per cent appreciation has occurred.

Similarly, the RBI could think of a regular widening of the exchange rate band within which it will not intervene, to resist either appreciation or depreciation. This band can be widened at quarterly or half-yearly frequency to keep up the pressure on market participants to protect themselves against the increasing risk of exchange rate fluctuations. The band can terminate at the point at which the threshold conditions with respect to financial sector restructuring and market development are achieved. This should also allow enough time for exporting and import-competing sectors to adjust to the new regime, in much the same way that they did between 2002 and 2007; surely they didn't need the full five years to do so.

So far, we have been looking at a floating rupee as the culmination of a long and elaborate process, which may never end. In today's global environment, we will be better off doing the reverse; accept a floating rupee as both inevitable and desirable and work backwards to satisfy some critical threshold conditions as quickly as possible.

The writer is Chief Economist, Standard & Poor's Asia-Pacific. The views are personal