Subir Gokarn: The rupee's smooth take-off

An average rate of appreciation of 2 per cent per year is similar to the 3 per cent that the Chinese have deemed to be non-disruptive.

Now that the quarterly monetary and credit policy announcement is out of the way, the macroeconomic policy focus must surely return to the critical issue of the exchange rate. The debate on what to do about it has been vigorous, on these pages and elsewhere, but, so far, it has not translated into a concrete statement about the direction which the policy is likely to take. Stopgap efforts to reduce capital inflows, like the restrictions on external commercial borrowings a couple of months ago, have clearly not had the desired impact.

Despite an increasingly turbulent global environment, the short-term and even the medium-term outlook for growth is quite positive. That is, ironically, the crux of the problem. With growth rate expectations in the 8-9 per cent range, funds will continue to pour in, in pursuit of the returns from growth. This is apart from any considerations of exchange rate risk, which tends to dilute returns earned in the domestic currency in a country in which the currency shows a possibility of depreciating.

The rupee, along with most other currencies in the neighbourhood, displays no such tendencies. If the only thing it can do is appreciate, it adds, rather than subtracts, to the returns earned by foreign investors, thus reinforcing the incentive for further investment. As long as the rupee remains undervalued, the pressure on it to appreciate will continue to increase.

This, of course, does not mean that the pressure cannot be resisted; it is just that it will become more and more costly over time. A combination of continuous reserve accumulation, expropriation from the banking system through increasing restrictions on lending (such as a higher cash reserve ratio) and larger issuances of government securities, the interest payments on which add to public expenditure, can keep the process going, and for a long time at that; our neighbours in East Asia have been doing essentially this for the last decade.

The main argument being made in support of this approach is that competitiveness in both exporting and import-competing sectors needs to be given some protection. Domestic producers should not be penalised by unfavourable exchange rate movements whose origins lie outside their sphere of control. The "Dutch Disease" that plagued the UK and the Netherlands as a result of their becoming oil exporters in the early 1980s, is afflicting Indian producers today as a result of large capital inflows and they need to be provided some immunity. The argument is reinforced by the fact that our most serious competitors in the global marketplace are also resisting appreciation, although to varying degrees.

In effect, this policy represents a subsidy to domestic producers, paid for by a consortium of banks (lending restrictions), the government (interest payments on securities) and domestic consumers (higher prices of imports). Like any subsidy, it needs to be evaluated in terms of its overall cost-benefit ratio, which includes a consideration of the alternative ways of delivering a given level of protection. For example, a combination of direct subsidies to exporters and higher tariffs on imports could have leave domestic producers no worse off, while allowing the rupee to be determined purely by market forces. The question is whether pegging the rupee is the most efficient way to achieve the objective.

Letting the rupee float is a clear option, certainly if tariffs and subsidies can be realigned in a way that is competitiveness-neutral, but even otherwise. For one, it is consistent with the general movement towards market determination of prices. For another, it will stop subsidising capital inflows by eliminating the appreciation premium that is being provided in the current situation. While it is the logical thing to do under our circumstances, as I had also argued in a recent column (Targets and Transitions, September 24), the concern is essentially with the speed of adjustment.

Within our own experience, gradual appreciation has not been particularly harsh on domestic producers. Between 2002 and early 2007, the rupee appreciated by about 10 per cent; during this period, export growth accelerated and the trade deficit remained relatively narrow. The same 10 per cent appreciation over a few weeks in 2007, on the other hand, saw a significant decline in the growth rate of the rupee value of exports and a significant widening of the trade deficit. An average rate of appreciation of 2 per cent per year is similar to the 3 per cent that the Chinese have deemed to be a non-disruptive transition.

Eventually, of course, everybody will either accommodate a significant appreciation through productivity gains and more effective use of hedging instruments or go out of business, but there is intrinsic merit in giving people some time to make the transition as well as the availability of efficient hedging instruments to expand.

However, the Chinese experiment notwithstanding, there are obvious limits to gradualism. Announcing a target rate of appreciation with a timeframe for a free float (the Chinese have not done the latter, to my knowledge) reinforces some of the very incentives that the change is trying to quell. In particular, it will induce short-term capital flows, which will try to take advantage of the guaranteed appreciation over the period. This, in turn, will ensure that each year's target is always met, in effect subsidising the short-term investments. Another instrument is clearly needed to neutralise this incentive. The one that comes to mind is the Tobin Tax, a tax on short-term foreign investments. It would have to be levied at a rate that would fully offset the appreciation premium over the time taken to let the currency float.

Essentially, we can pose this whole issue as a design problem. The objective is to move towards a market-determined exchange rate with the minimum disruption to domestic producers and other macroeconomic variables, such as the fiscal deficit and the inflation rate, while reinforcing incentives towards longer-term capital inflows. The direct instruments are export subsidies, tariff rates, the Tobin Tax and, importantly, the time frame over which the process is to unfold.

It may finally turn out that no intermediate solutions are superior to the two extremes of the rupee staying on the ground by virtue of appreciation being resisted or a vertical take-off as a result of an immediate float. The possibilities are, however, worth exploring and may well give us a stronger analytical foundation for making a choice between the two.

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