Managing the external economy

THE FALL OF the rupee against the dollar to below the forty-four level on Wednesday ought to be viewed in its correct perspective. All indications are that the sharp decline of about 35 paise was caused by a sudden and unexpected commercial demand for dollars, leading to a wrong market perception that the rupee would move down even more steeply in the next few days. The result was a classic panic reaction especially among importers, who rushed in to cover. Additionally, the fact that the dollar has been faring well against the euro and other major currencies in the international markets has naturally mattered in India too. Important as these causative factors are, it is imperative that a distinction is made between short-term and medium-term influences that affect not just exchange rate stability but the external sector management as a whole.

For a long time since end-August 1998, the Indian currency has enjoyed, by the standards of today's foreign exchange markets, a period of reasonable stability. The Reserve Bank's strategy involving a combination of a tough posturing against speculative elements along with correcting temporary imbalances in both demand and supply has paid off. Since the day-to-day movements of the exchange rates are market determined, the RBI's claim of having enforced orderly conditions cannot be disputed even when the rupee lurches below a psychological barrier of Rs. 44 to the dollar. Given the fact that a gradual depreciation of the rupee has always been on the cards, there is apparently no reason to be especially concerned even over Wednesday's sharp drop. In its recent annual monetary and credit policy statement, the RBI has reiterated that it will continue to closely monitor the financial markets and take all appropriate measures to achieve certain stated objectives.

Those objectives will have to inevitably mesh with the much broader goals of external sector management and of macroeconomic policy. The growing linkages among the different sectors of the economy and among the several financial markets prove that sector-specific measures have become passe. The sudden weakening of the rupee might just be a perception that was proved wrong by subsequent developments but then the original anxiety arose from the recent stock market gyrations. Foreign institutional investors, who have suddenly turned net sellers of stocks, were reportedly repatriating the proceeds abroad. There could be further threats to the forex market's composure, if inflationary pressures are to be countered through monetary means.

Further areas of concern relate to the balance of payments and the management of reserves. During the last financial year the sharp increases in the prices of crude oil and petroleum products caused the oil import bill to go up substantially. Even though it was absorbed without causing undue strain on the current account deficit, there is obviously no room for complacency. In fact current thinking on reserves management would factor in contingencies such as an unexpected commodity or asset price increase. Another fascinating external economy debate centres on debunking age-old assumptions regarding the adequacy of forex reserves at a given level. Thus while there has been a satisfactory accretion in the country's reserves during fiscal 1999-2000, experts say that in emerging economies a number of parameters besides the quantum of merchandise imports or the size of the current account deficit should be used to determine the adequacy of reserves. Since capital flows have become volatile, their composition obviously matters in determining the adequacy of reserves. The overall approach to the management of the country's foreign exchange reserves and therefore of exchange rate policy is all encompassing and includes both identifiable factors and contingencies. There would be some more salutary gains if Wednesday's drop in the rupee spawns further discussions in that genre.

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