Sudhir Mulji: Revaluation and all that

Solving the problem of excessive forex through rupee appreciation may have unwanted consequences

One solution to the problem of accumulation of foreign exchange reserves as proposed by Subir Gokarn (Business Standard, December 6) is to revalue the rupee.

Presumably this has the merit of enhancing the exchange value of the domestic currency.

But readers will recollect that in the late 15th and early 16th centuries, Spain's foreign trade was destroyed by an abundance of gold, which increased labour costs to the point of the country losing its competitive capacity.

It had been assumed that an inflow of gold would suffice as compensation for the loss of product markets, but that turned out to be a delusion, and Spain gained nothing from the inflow of precious metals, apart from the financing of unnecessary wars.

The modern equivalent of gold is inflow of foreign exchange combined with an insufficient use for it. The fact that revaluation is a valid possibility for India cannot be denied.

Perhaps all it requires is to desist from sterilising foreign exchange inflows. However, one should not ignore the consequences to our balance of payments. The most substantial credit item in our current account is inward remittance.

A sum of $20 billion annually is credited to the account without any obvious liabilities. It would be unwise to allow this useful and steady flow from the Indian diaspora to be experimented with.

Clearly if markets provide incentives, an under-valued exchange rate should be a positive factor in encouraging this inflow. Any substantive re-valuation could undo this incentive.

One theory is that remitters to India have a need for rupees to support their families in India; but such demands have a fickle quality about them and can easily be diverted away from India.

Further, if we adopt Ricardo's analysis of exchange rate determination, another interpretation of the potential strength of our exchange rate could be validly argued.

For "advocates of the monetarist approach argued convincingly that exchange depreciation originated in excessive money growth and that the monetary authorities could have stopped the depreciation had they been willing to exercise control over the money stock" (Humphrey, "Adam Smith and the Monetary Approach to the Balance of Payments," published by Elgar, 1993).

It follows from this argument that if an exchange depreciation is a consequence of too much money supply, an exchange appreciation could be caused by too little money supply.

Thus, if the demand for foreign exchange was not supported by the Reserve Bank's willingness to buy the currency, we might find a rapid fall in domestic demand for foreign exchange, thereby revaluing the currency to a point where the supply of foreign exchange disappears.

As to the choice to be made between the two logical alternatives, of either increasing the demand for money or revaluation, is there any case for preferring a revaluation?

Such a move would reduce the cost of imports but to some extent reducing or even eliminating tariffs could achieve the same result. The real danger with a re-valuation strategy is its impact on non-traded goods, in particular the cost of labour.

An effective re-valuation would increase the cost of labour in foreign exchange terms, and, since we earn a great deal from remittance through the export of labour, revaluation could have a damaging effect.

Further, we supply the world with trained labour in the field of seafarers, bankers, doctors and nurses, and to an increasing extent, with medical facilities and services.

An effective rise in these costs would be highly detrimental, not simply to the balance of payments but also to the employment prospects of our surplus manpower. If we believe that we have surplus labour that needs to be actively used, there seems little merit in raising the cost of it by revaluing.

Further, the consequences of higher labour costs in terms of foreign exchange may not be negligible. We have already pointed out that inward remittance, the consequence of supplying labour to foreigners, is the largest single credit item in our balance of payments, and one should be reluctant to disturb this contribution to our resources.

Thus, while revaluation is certainly an alternative to excessive inflows of foreign exchange, its resolution by an up valuation of the exchange rate may have unwanted consequences.

Subir Gokarn argues, "Even if one concedes that an appreciation does hurt competitiveness ... it is not necessarily incumbent on the central bank to prevent it."

This may indeed be the case. From the point of view of managing foreign exchange and money supply, our competitiveness may seem not to matter, but it would be a rare authority that would adopt such a cavalier attitude to export markets.

We may deem it right to increase imports, but surely we have not reached the point where we can be indifferent to exports. A central bank would be obtuse to claim that the competitiveness of the economy is not its business.

But on more analytic issues, it has been a theme of this column that the supposed classical moorings of what goes down for orthodox economics are not as firmly established as the orthodox may imagine.

First, there is considerable controversy even among the classicists as to the precise assumptions required for the system to operate.

Classical conclusions are not as uniform as is generally assumed. But it would be fair to say that some factors have been relatively firmly established.

The first of these is that an excess supply of money by way of inconvertible money would lead to a deterioration in the exchange rate; the second and somewhat more tentative one is that the proportionate premium on the price of convertible money in terms of inconvertible money establishes the extent of over- supply of inconvertible money.

It was from these principles that the bullionists laid the foundations for the modern monetarist theory that the exchange rate between two countries varies in proportion to their relative inconvertible money supplies and that exchange rate movements are therefore a purely monetary phenomenon.

A variation on this general theme is for the authorities to purchase by law surplus convertible funds and stock them in a central pool by selling inconvertible funds in exchange.

It is to be expected that the inconvertible funds thus sold be at a premium; an up valuation of the currency should, to reduce or eliminate this premium.

The alternative scheme is to use up some of the convertible currencies in new ventures like infrastructure projects. But sadly this exercise has a cost. By purchasing convertible currencies for the central pool an agency like the Reserve Bank of India will have paid for this.

Admittedly, it will have done so in inconvertible currencies, but nevertheless a price including a premium will have been paid. In any proper accounting system, this agency must be paid back at the rate prevailing, and in paying its own creature the sovereign has to incur an expense.

Now it is the sovereign's right to create as many notes of the inconvertible currency as he dares, and the further cost may turn out to be negligible if the community has many idle persons.

This is the essential bet that is now at stake between the Planning Commission and the finance ministry. In determining this bet a revaluation has nothing to contribute.

sjmulji@aol.com