Credit policy is also for learning

The monetary and credit policy statement's impact and appeal extend far beyond its target group.

By C. R. L. Narasimhan

Last week's credit policy was, as expected, devoid of any headline catching announcement such as a Bank Rate cut or a cash reserve ratio (CRR) reduction. However, the policy statement is a mine of information on many aspects of the economy which, though esoteric to many, are extremely vital.

One of the stated goals of the Reserve Bank of India is to enhance customer service for which customer education is a prelude. There are other welcome implications: a process of democratisation has set in in the area of economic decision making. Ordinary citizens who have a stake in the decisions ought to be made aware of the intricacies. The RBI's elaboration of some crucial issues such as the external economy (discussed here) is therefore doubly welcome: last week again it was when there were renewed concerns over the external value of the rupee.

Tracing the significant changes in the external environment over the past few years, the RBI says that during 1999-2000, despite a sharp increase in oil prices foreign currency assets of India had increased by $5.5 billion. The forex markets were reasonably stable.

During the first half of the next year (2000-01), however, there were adverse developments. Particularly between mid-May to mid- August 2000, the impact of continued high oil prices was felt. In the U.S. and Europe interest rates went up. This meant lower capital inflows into India and a decrease in forex reserves by $2.5 billion in the first six months of the year. There was considerable instability in the forex markets with the rupee depreciating by as much as 5.3 per cent in dollar terms between April and September 2000.

During the second half, however, there was a significant turnaround. Forex assets increased by $7 billion (of which $5.5 billion came from the India Millennium Deposit scheme). Exchange rates were generally orderly and range bound during the period.

The forex market's behaviour was vastly different during the two halves of the year even though there was no significant change in the ``real economy'' or economic variables such as the growth rate ,trade deficit or oil prices. By all parameters the first half should have witnessed orderly conditions. Reserves (average $36.7 billion) were extremely comfortable and exports grew by more than 20 per cent in the first half. The RBI had indicated that it would meet the forex requirements of oil imports as well as government debt repayments.

Yet the market remained unstable during the first half as compared to the latter part of the year.

From the sharp turnaround and the behaviour of the forex markets last year certain important messages for the management of external sector arise.

(a)The day-to-day movements in the forex markets, in the short run, have nothing to do with the so called economic fundamentals or the country's capacity to meet its payment obligations, including debt servicing. Adverse news and expectations play a paramount role. They are also self-fulfilling because of their adverse impact on leads and lags in trade receipts and payments and inter-bank positions.

(b)Inter-bank activity sets the pace in forex markets :transaction volumes in gross terms are several times higher and more variable than net flows. Exchange rates are more sensitive to gross flows and variability in gross flows in turn is sensitive to exchange rate expectations.

(c)Adverse news has the effect of exacerbating an initial adverse exchange rate movement. That is inevitable considering the bandwagon effect of inter-bank trading and the herd mentality of participants.

(d) Especially in developing countries where the size and composition of the forex market is small ,the bandwagon effect is more pronounced. Moreover in India, relative inflation rates are higher than in the West and the rupee is on a depreciating trend. Market players hold long positions in foreign currency when the rupee is depreciating or when there is an expectation that it will decline.

(e) Importers and exporters sometimes look at exchange rate movements for making money without adopting appropriate risk management strategies. This can create severe and uneven mismatches between demand and supply .As the RBI puts it succinctly, ``A self-sustaining triangle of supply-demand mismatch, increased inter-bank activity to take advantage of it and accentuated volatility triggered by negative sentiments not in tune with fundamentals can be set in motion requiring quick intervention by the authorities''.

Central banks the world over therefore find it difficult to frame appropriate exchange rate and market intervention policies. At present there are two extreme views on how to manage a country's exchange rate. At one end is the mechanism of freely floating rates without any intervention by the central bank. At the other end is the currency board type arrangement of fixed rates. In practice, however, most countries have opted for intermediate regimes, a via media between the two extremes.

Barring very few countries ,all others have adopted regimes such as fixed pegs, crawling pegs, fixed rates with bands, managed floats with no pre-announced path and independent floats with intervention by the monetary authority to even out undue fluctuations. India follows a managed float. The market by and large determines the external value of the rupee. But the RBI intervenes if circumstances so warrant.

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