Suman Bery: An inconvenient truth

An appreciating exchange rate has been good for the economy.

In recent months Indian monetary management has received its share of knocks from several distinguished contributors to these pages. Capital surges towards emerging markets have become a regular feature of the international economy over the last fifteen years, tracking the cycle of monetary easing and tightening in the developed world. Handling them has accordingly become part of the toolkit of financial authorities in all major emerging markets.

While events over the last week suggest that the cycle might once again be turning, the distinct sense conveyed by the critics mentioned below is that the most recent surge has been handled with considerably less aplomb by the Finance Ministry and the Reserve Bank of India (RBI) than in the past.

The sharpest criticism (particularly by Shankar Acharya: "Midsummer Madness?", Business Standard, August 9, but also Surjit Bhalla and AV Rajwade in various columns) is that excessive (and excessively rapid) nominal exchange rate appreciation (particularly in March of this year) has been permitted by the RBI.

In addition Acharya, citing several articles by Rajiv Malik of J.P.Morgan, argues that progressive liberalisation of external commercial borrowing (ECBs) for Indian corporates was irresponsible, given the magnitude of other capital flows heading India's way.

Acharya is forthright about the preferred response, which is to repeat the earlier drill:

Reserve Bank purchases of foreign exchange ("intervention") should keep the nominal exchange rate within a range loosely related to a real exchange rate target;

The monetary impact of such purchases should be neutralised ("sterilised") through sales of government securities [or increases in minimum required cash reserve ratios (CRRs)] to hit either liquidity or interest rate objectives;

Although he personally believes that intervention can be continued indefinitely and is almost wholly successful for good measure he proposes sharp restrictions on the volume of ECBs, presumably to limit pure arbitrage operations.

Despite being a committed liberaliser in other spheres (notably trade and taxation), Acharya justifies this enormous exercise of discretionary power by the RBI on the grounds that not to do so is likely to impose "significant, rising and avoidable costs for exports, output and employment".

Similar concerns have been expressed by Rajwade in his columns, drawing in part upon case studies of the impact of the rising rupee. These are reinforced in his article of August 20, where he strongly endorses the use of increases in the CRR as the preferred sterilisation instrument. Surjit Bhalla, in his BS column of August 18 ("How India is different from China") provides specific orders of magnitude on the growth benefits of sterilised intervention.

Acharya, Bhalla and Rajwade (ABR) are all serious, responsible and experienced commentators, and a shared consensus among them cannot be taken lightly. In his August piece, Acharya attributes the recent deviation from past practice to arguments "peddled in recent months by some IMF staffers and a small group of younger domestic economists". While no longer young, and never with the IMF, I was mildly surprised not have been bracketed in the same company. I would, however, admit to the same lack of "hands-on, policy-making experience" which Acharya considers essential for credibility in these matters.

Starting with a joint paper with Deepak Lal and D K Pant in 2003, and more recently in these columns, I have been among those who have been arguing for greater nominal exchange rate flexibility, including appreciation when the occasion demands it. Quite apart from the analytic points that I make below, I feel that such flexibility is to be welcomed because it reduces the risks associated with the necessary, desirable and inevitable integration of the Indian financial system into world markets.

There is clearly no disagreement between ABR and myself on the ultimate goals of economic policy. These are to provide high, efficient, sustainable non-inflationary growth. Where we apparently differ is on the importance of the tradables sector (both manufacturing and services) in generating such growth, and on the appropriateness of intervening heavily in financial markets to bring about an ever-increasing share of tradables in national output.

The polar case of such a strategy is China, and it is dubious that we either should, or can go down that path.

The view that Lal, Pant and I took in our 2003 work is that the fundamental driver of growth is efficient investment. This is most easily achieved by a judicious widening of the current account deficit (which allows foreign savings to enter the economy so as to supplement domestic savings) and by allowing the nominal exchange rate to track underlying movements in the "real" exchange rate (not the real effective exchange rate), which is the domestic relative price of tradables to non-tradables. The real exchange rate is basically responsive to the domestic imbalance between demand and supply.

On such a view, exchange market intervention leading to reserves accumulation frustrates the widening of the current account that would permit enhanced investment while sterilisation, through its impact on domestic interest rates, exacts a further toll on investment and growth. On this view, the recent growth acceleration is precisely because monetary and fiscal policy eased sufficiently to permit the current account deficit to record a modest deficit.

As events have unfolded we have also seen that a strong rupee benefits some constituencies even as it may harm others, quite apart from the fact that it makes Indian assets more expensive to acquire and overseas assets cheaper. Finally, it is specious, arbitrary, and in the last instance impossible to draw fine distinctions between "good" and "undesirable" forms of capital inflow.

In brief in a fast-moving economy subject to myriad positive and negative shocks it is difficult to take a view on the equilibrium real exchange rate which will in any case vary across the economic cycle. Over the medium run it is clear that the real exchange rate will appreciate. The true concerns of macro managers are external and internal balance. As long as these are achieved, the composition of output is best left to the market to determine.

To conclude, I accept that there are pragmatic limits to the amount of nominal appreciation that is politically tolerable in a given space of time; also that the stability of capital flows is uncertain. My basic objection is to targeting a given effective exchange rate as an instrument of development policy. In this I do seem genuinely to differ from my esteemed fellow columnists in these pages.

The writer is Director-General NCAER. The views expressed here are personal. sbery@ncaer.org