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Why canonise exchange rate

Exchange rates are no longer a barometer of the economy's fundamentals. Those determined solely by market forces are found only in textbooks and, perhaps, in the IMF mythology. The RBI need not, therefore, be apologetic about its intervention. There is t he need to make the exchange rate objectives subservient to the objectives of the monetary policy, says N. A. Mujumdar.

THE recent depreciation of the rupee against the dollar and the Reserve Bank of India's response have generated a debate on exchange rate management. Some experts argue that such depreciation represents a correction occasioned by inflation differentials between the two countries. Others are for allowing the rupee to find its own level by free play of market forces and that the RBI should not have intervened, perhaps lending theoretical support to speculators who believe that the real exchange rate shoul d settle at, say, Rs. 50 to a dollar.

This sort of reasoning would be tantamount to investing the exchange rate with a degree of sanctity it does not deserve and that canonisation of exchange rate is totally unwarranted. In today's world, exchange rates are not a barometer of the underlying fundamentals of the economy. Management of the exchange rates seems to be the rule rather than an exception. Exchange rates determined solely by market forces are found only in textbooks and, perhaps, in the IMF mythology.

The RBI need not, therefore, be apologetic about its intervention. In the Indian context, there is a need to take a holistic view of the exchange rate policy. First, there is a strong case for making the exchange rate objectives subservient to the domest ic objectives of the monetary policy -- promotion of growth with price stability. Second, foreign exchange reserves management should be treated as an integral part of exchange rate policy. The decline in the foreign currency assets by $ 2.1 billions thi s fiscal up to August 4, is an important factor exerting pressure on the rupee. Unfortunately, the RBI has shown singular lack of vision on this aspect of policy. It must address immediately this issue of demonstration effect of the decline in reserves o n the rupee-dollar rate.

The basics

Addressing an IMF Institute seminar on July 15, 2000, the well-known MIT professor, Rudi Dornbusch, opened his presentation with a conundrum -- economists do not have good models to explain exchange rate movements, particularly short-term movements, but exchange rate movements have an important impact on other economic variables such as GDP, inflation and the current account of the balance of payments. Policy-makers are, thus, in a bind. On the one hand, exchange rate arrangements and policies are too i mportant to be neglected; on the other, the value of any advice on these matters is hampered by the lack of a good understanding of what factors move exchange rates, particularly in the short-run.

The familiar ``purchasing power parity'' (PPP) law is unable to explain changes in exchange rates, which often take large and persistent swings away from the values suggested by PPP. Other fundamentals, such as GDP growth, money supply expansion and inte rest rates, also are in no better position to provide a satisfactory explanation.

Prof. Dornbusch, therefore, adds that economists have now turned to what he calls market microstructure as a possible explanation of exchange rate movements; the components of this structure include behaviour of participants in the foreign exchange marke t, their risk preference, their `inventories' of different currencies and other such elements. Poor forecasting capabilities may also play a role. Indian commentators on the recent dollar-rupee rates volatility may, perhaps, benefit from these discussion s (IMF Survey, July 31, 2000).

The fundamentals

Just because the dollar-rupee rate touched Rs. 45.80 on August 23, one must not read too much into this volatility. Expressions such as rupee `nose-dives' or ``touches an all-time low'' need not lead one to misconstrue that something is fundamentally wro ng with the economy. One has only to study Prof. Dornbusch's `market microstructure'. There is nothing to panic about the Indian economic situation and the fundamentals are quite strong. That is where the demystifying of the exchange rate movements as a barometer of the strength of the economy begins.

In fact, the RBI has done a commendable job of clearing a lot of confusion surrounding the exchange rates. In its detailed statement of August 3, it clarified that the depreciation of the rupee is confined to the dollar. For instance, between July 1 and August 2, the dollar appreciated by nearly 4 per cent against the euro, by 3.2 per cent against the yen, and about 1.5 per cent against the sterling. As a result of these changes in the dollar, the rupee strengthened against the euro by 2.5 per cent, and by 1.5 per cent against the yen, and remained stable against the sterling. The euro, pound and the yen are the currencies of India's major trading and investment partners. Thus, taking a holistic view of the rupee's movements against the currencies of I ndia's major trading partners, it makes little sense to beat our breasts about the falling rupee.

Turning to the fundamentals, the economy would post a GDP growth of more than 6 per cent for the third year in succession. Thus, the economy has graduated to a high-growth trajectory. Second, there is unusual buoyancy in exports. In the first three month s of this year, export growth was as high as 28 per cent. Third, the new National Agricultural Policy aims at raising the farm growth to 4 per cent per annum by 2005. This is to be achieved through a combination of measures, including structural, institu tional, agronomic and tax reforms. Fourth, despite the unusually high international prices of oil, India's balance of payments outlook remains encouraging.

For instance, the impact of these high prices on the import bill is estimated to be $12 billions in 1999-2000. Fortunately, such an increase in the import bill was absorbed without any undue pressure on the overall current account deficit, which remained at a modest level of 1 per cent of GDP. It was possible to contain the current account deficit by a turnaround in exports, lower growth of non-oil imports and continued buoyancy in invisible receipts.

International oil prices continue to rule high this year also, but the RBI estimates show that the current account deficit would be much below 2 per cent of GDP in 2000-01. In addition to the software segment, which is contributing greatly to the buoyanc y of the invisible earnings, there is yet another segment to which attention needs to be drawn. India is emerging as a natural choice for foreign companies looking to out-source their non-core functions. A number of their activities are amenable for such out-sourcing, and India needs to exploit this opportunity fully. Thus, the balance of payments outlook continues to remain healthy.

Political economy considerations

It must be added here that exchange rate determination falls into the realm of political economy. A recent IMF study has shown that interventions in the yen-dollar rate in the 1990s have had small but persistent effects. Interestingly, in Japan, the auth ority to intervene is vested with the Ministry of Finance, which gives the orders to intervene and the Bank of Japan carries out the actual intervention by either buying or selling foreign currency depending on the objective of intervention. In the US, b oth the Federal Reserve Board and the Treasury have independent legal authority to intervene. In practice, however, it has largely been the Treasury that decides on the intervention and the Federal Reserve Board carries out the intervention through New Y ork Federal Reserve Bank.

Historically, it may be recalled that it was the unilateral decision of the US government to float the dollar in 1972 which wrecked the very foundations of the fixed exchange rate regime built up so assiduously by the IMF over the years.

It must be emphasised that the domestic monetary policy objectives of promoting growth with price stability should form the core of macroeconomic management. The exchange rate policy should operate at the periphery. Fortunately, India has taken the wise decision of not moving towards full convertibility of the rupee. The East Asian currency crisis in a way proved the validity of such a decision. Now even the IMF is cautioning the emerging economies to go slow on full convertibility. Circumscribing the r ole of exchange rate in macroeconomic management should, thus, form an essential part of any future strategy.

This limited convertibility of the rupee would need to be buttressed suitably by a more meaningful forex reserve management, the objectives of which are to build reserves of a robust magnitude, at the same time utilising them to accelerate GDP growth and increase export capabilities. The RBI's track record in this is disappointing; its approaches to the twin problems are direction-less and betray lack of vision. Take the case of end-use of forex resources raised by corporates. The end-use was regulated in the initial stages, then partially regulated and now totally freed. In fact, the RBI's recent directive to repatriate 50 per cent of the balances held in the Exchange Earners Foreign Currency (EEFC) accounts itself added to the ``panic psychology'' of the market sentiment -- an element on which speculators flourish. The real question is not why the RBI issued such a directive at this stage, but why in the first place such freedom was granted to EEFC account holders.

The profligacy in the use of forex is writ large on recent policies. What purpose on earth gold imports of $7 billions per year are designed to serve? Surely, the WTO did not ask the Government to ensure free import of gold. Did we raise $4 billions of f orex through the issue of Resurgent India Bonds (RIBs) to finance the import of gold? We seem to have become so affluent in forex that today even money changers can release exchange up to $25,000 to a person for business travel, irrespective of the perio d of stay. Again, there is the demand for permitting Indian savers to invest, within limits, their savings abroad. We have begun to import not only apples from New Zealand but also dog food from France! In fact, such frittering away of forex is reminisce nt of the wasteful utilisation of the huge sterling balances in the post-War period.

These disturbing thoughts are raised merely to demonstrate the absence of a concerted policy aimed at building forex reserves of a robust magnitude, the size of which could act as a deterrent to currency speculation. For instance, there is no reason why India should not seek to maintain total reserves of say $50 billions -- equivalent to the value of one year's imports. This objective, coupled with the policy of making productive use of part of the reserves, should form an integral part of the exchange rate management philosophy.

(The author is a former Principal

Adviser to the RBI.)