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RBI confronts the inconsistent twins

D. Sambandhan

There is no single route to defend a currency in trouble. While engaging the market through intervention and interest rate hike, the RBI has found itself sinking into a treacherous quicksand.

The authorities have faltered in delineating and discovering the range of opportunities, resulting in the twin prices of interest and exchange rates going out of control and inflicting enormous economic injury. The central bank should never attempt the i mpossible and create distortions between the twin prices.

THE RECENT fall of the rupee against the dollar, now arrested by the RBI by ordering the repatriation of idle dollar balances held abroad by corporates, has all the ingredients of drama -- ``the confrontation of opposing forces''. The misplaced feverish enthusiasm or the romantic desires of the corporate sector for the continuance of a softer interest rate regime, ultimately articulated and revealed through the easy Monetary Policy last April, has crashed against the reality of hardening of interest rat es and the fall of the rupee.

That even without that policy error, the rupee would have fallen is an altogether different matter. Not only the standard sequence of events inherent in any episode of currency crisis, evident in the recent interest rate mess and rupee plunge, but also m any more insights are available.

International Fisher effect

The management of twin prices -- interest and exchange rate -- representing both internal and external price of money respectively, cannot be separated from each other, as they are networked through the international Fisher effect. The essence of this si gnificant parity condition of international finance is that in a highly integrated open economy, in the face of expected depreciation of domestic currency, the domestic interest rate must jump so as to prevent the plausible and profitable capital flight.

In a land of limited capital account convertibility such as India, it is possible to tamper this theorem for a short while. Moreover, a host of restrictive assumptions underlying this condition may not hold good in this situation. However, in the context of growing links between forex and money markets and the resultant profitable channel available for making arbitrage profit, the option for a cheap money policy does not just exist, especially when the rupee is more vulnerable. There is no such thing as autonomy over interest rate, when the currency is unstable. Further, even the sterilised intervention has its own limitations and repercussions for the twin prices.

Misplaced comparison with major players

Any kind of misplaced comparison with developed economies over their relative degree of freedom in operating with competitive and compatible twin prices, especially the rate of interest, will not hold much appeal in developing countries such as India, un less, of course, a full-fledged integration of money and capital markets has happened to push down the level of interest rate at home. But the fact is that a great deal of a symmetry exists in the process of capital flows among nations and they are tilte d in favour of the affluent and against the emerging markets.

Consider and contrast the rupee experience with major players. Throughout the 1990s, the US economy had forged ahead and happily this came, along with low inflation and the lowest-ever unemployment rate. With the exception of the mid-1990 currency collap se, for most period, the dollar was on the rise and much sought after and the interest rate regime was also benign. Furthermore, the US, with its continuing key currency status and dollarisation attempts elsewhere, can still afford to print money and cam e out of a recession without any immediate repercussions for its exchange rate. The US' benign neglect of exchange value of dollar continues even under the current floating exchange rate regime.

It was only when the financial meltdown in South-East Asia had its final spillover effects on the US market, threatening loss of control over inflation, did the Fed chairman, Mr. Alan Greenspan, resort to a tight money policy. The series of hikes in the short-term interest rate in the US this year were intended to dampen inflation and prick the speculative bubble on stock prices, but they were also needed to prop up the dollar. With the growing dollar strength, the escalation in short-term interest rate was abated for a while, giving temporary relief to euro.

In sharp contrast, Japan has been in a state of perennial slump since 1991, afflicted with a moral dilemma of zero interest rate and continual negative inflation rate. Asserting its independence, the Bank of Japan recently reversed the longish zero inter est dilemma and hiked the bank rate to 0.25 per cent, defying the Finance Ministry, as the policy of insulating Japan from the deflationary threat was no longer relevant. A ridiculously low consumer spending has been the major contributory factor for the stagnant economy.

Fortunately, the levels of growth lay in the external sector, resulting in a sizable current account surplus, thus navigating Japan to some measure of economic safety. Japan could afford to near-zero interest rates and allow the exchange rate to settle a t whatever level it finds. India does not enjoy that freedom.

Impact of irrational easy money policy

But, precisely, the RBI did exercise that illusory freedom rather naively, propelled by political forces and vested interests. By easing the Monetary Policy, it pushed the effective interest rate to a ridiculously low level, far lower than international standards. When considered against the hardening of interest rates world-wide, including in the US in the second quarter of 2000, leading to a resurgent dollar, and the consequent weakening of even the traditionally strong currencies, the RBI's way of ma naging the twin prices is indeed puzzling. Perhaps, the long period of rupee-dollar exchange rate stability within a narrow range in 1999-2000 might have additionally seduced the policy-makers to take a calculated risk against a possible expected exchang e depreciation.

Translated into the language of international finance, the direct and most obvious result of this irrational act was to signal to the market that the authorities would not be averse to a depreciation of the rupee. A benign interest rate regime combined w ith the loosening of the current account transaction in the post-QR phasing out era and a sharp rise in the price of oil, propped up the merchandise demand for spot dollars. But the much-needed supply, which was to come from exporters and autonomous capi tal flows (FIIs and FDI), became stifled because of the ``leads and lags'' and they were only a trickle, given the natural expectation of the rupee depreciation. The market could not be faulted for choking the supply of dollars in view of the enormous ga ins involved.

When the rupee-dollar crisis surfaced in the second quarter, the alternatives available for the RBI were intervention in the forex market and deploy the interest rate instrument. One of the alternatives, of course, was ``to do nothing'' and the RBI did t hat for some time. Then, intervention was resorted to in the face of a frightening fall of the rupee, resulting in a loss of more than $1 billion. Having lost reserves, the bank rate, the CRR and the repo rates were hiked when the rupee touched the expec ted psychological level of Rs. 45 to a dollar. Besides arresting the rupee slide swiftly, it did have a magical effect for a few days, notwithstanding its savage influence on stock prices through the FII route of panic, assisted by the Bal Thackeray fact or. How cruel a rise in interest rate can be in a politically surcharged environment, the July 2K episode bears ample testimony.

Tightening of Monetary Policy

Using the interest rate instrument to supplement active intervention in the forex market is a time-honoured first line of defence to rescue a currency from speculators' attack. However, the July 21 RBI measure of a tight money policy ``makes nothing to h appen'' in a more outward and visible way, and the market was tuned towards further depreciation of the rupee, reviving the memories of the 1997 baht crash and the 1991 currency shock. Perturbed by the frightening and panic fall of the rupee, the RBI cla rified by issuing statement of the developments in the forex market that the economic fundamentals were reasonably good and that, more or less, the RBI was adhering to restoring an effective real exchange rate and not targeting any particular nominal exc hange rate; but that came too late to provide comfort to the rupee.

Since the anchoring of the exchange rate around Rs. 31.37 per US dollar for 20 long months during the days of Liberalised Exchange Rate Management System (LERMS) and unification of exchange rate around mid-1990s, the rupee has

jumped at a discrete time interval by Rs. 3 per US dollar. This great deal of exchange rate flexibility in the case of the rupee partly explains why the currency was not subject to any serious damage at the height of the South-East Asian currency crisis in the late 1990s. Thailand's baht was held rigidly with the US dollar for 12 years (1985-97). The same was the case with its neighbours. The flawed logic behind the rigid dollar peg was exposed and the failed fixed exchange rate regime was also a remind er that the capital flows-induced stability of exchange rates could be easily reversed and, even worse, some of them would eventually become the candidate for devaluation. The art of controlled flexibility by the RBI saved the rupee from the ``embarrassi ng over-valuation'' at that time.

The current problem of rupee is not merely the manifestation of mismatch between the supply and demand; nor is it due to simply a question of a massive trade balance deficit since current account deficit, by any international standard, is still manageabl e and viable. But, unfortunately, the historically-given misguided focus on bilateral rupee-dollar exchange rate and the deep-seated misconceptions about the gain of exchange depreciation, well-articulated by champions of the swadeshi lobby, have emerged as the prime villain of the piece.

In an environment of the US dollar hitting the roof and a fresh bout of depreciation sweeping devaluation-prone countries of South-East Asia (contagion effect), the single-minded focus on the rupee's fall against the dollar by a modest amount acquired a larger-than-life image to the relative neglect of its rise against the yen and the euro, not to speak of its overall stability against the currencies of major trading partners.

Although the catharsis of the rupee-dollar exchange rate may be explosive now, it is better this way than have it bottled. There is no need for alarm for the crucial economic fundamentals such as core inflation rate (ex-energy) and current account defici t (less than 1.5 per cent of GDP) are less worrisome.

Relevance of RBI

There is no single route to defend the currency in trouble. There are as many strategies as there are currencies, and the central bank has to resolve the transnational dilemma of the contagion effect, involving the twin prices. While navigating the trech erous waters of the forex market, the central bank should carry its unique experience, judgment and instincts. It should never attempt the impossible and create distortion between the twin prices.

While engaging the market through intervention and interest rate hike, the RBI has found itself sinking into a treacherous quicksand. With all experiences of past choices between interest and exchange rates that could be compatible and competitive, the a uthorities have now faltered in delineating and discovering the range of opportunities -- what is actually available and what you can afford. Result: The twin prices are going out of control, inflicting enormous economic injury.

Even in this age of loosening of current account convertibility and limited capital account convertibility, some tend to forget the basic role of the RBI -- to be there and insist that the market will be the arbiter. The RBI's recent (August 14) measures of scaling down the freedom of the corporate sector to hold foreign exchange overseas -- another significant way of slapping controls on this sensitive/precious good, will surely contest the conventional wisdom which holds that left to itself market wil l behave and find a true equilibrium exchange rate.

The RBI, fatigued more easily now, can draw comfort from the recovery of the rupee. Though it cannot ignore political voices, it should not allow itself to act beyond the structure and boundaries defined both by global monetary developments and domestic fiscal situation.

It is time the RBI was given the kind of autonomy enjoyed by the Bank of Japan; it can hone up its skill and reach a satisfactory compromise between the twin prices. With massive government borrowing in the pipeline impacting the interest rate, the press ure in the forex market still persists and the FIIs playing a hide and seek game in the stock market, the menace of speculative portfolio capital doing maximum mischief in pursuit of unbridled profit (largest outflow in July 2000), India can ill-afford t o opt for the softer interest rate regime.

(The author is on the faculty of the School of International Studies, Pondicherry University.)