Overheating, Exchange Rates, and Foreign Capital
by Arvind Subramanian, Peterson Institute for International Economics
Op-ed in Business Standard
May 10, 2007
© Business Standard
There is no mistaking it. Exchange rate policy has undergone a marked change in the last few weeks: from attempting to stabilize the nominal rate via intervention and then sterilizing the liquidity consequences, the RBI is now allowing the nominal rate to appreciate. The rupee has soared from about Rs. 44 to the dollar to about Rs. 41 to the dollar within a few weeks. Here’s a rash prediction. This policy will not, cannot, last. To understand why it is useful to see how we got here in the first place.
Inflation in India picked up over the last few months while capital inflows continued to surge. These twin developments placed the RBI in a quandary. Combating inflation required a tightening of monetary policy, which can be achieved by a combination of rising interest rates and an appreciating currency. On the other hand, maintaining competitiveness required resisting the appreciation pressures stemming from the capital flows.
What did the RBI do? It muddled through. And understandably so. To prevent the nominal appreciation it intervened in the foreign exchange markets (that is, it bought up the dollars). But this increased the supply of liquidity which ran exactly counter to what the doctor ordered for combating inflation. To offset this liquidity expansion, it sterilized the intervention, by issuing interest-bearing securities to the banks, which in return sold the rupees back to the RBI. But when you increase the supply of interest-bearing securities, their price, namely interest rates, tend to go up, or more strictly tend to be higher than otherwise. Domestic agents, especially corporates, found it advantageous to borrow in dollars, which resulted in further inflows. The tail started to wag the dog.
The inducement to borrow in dollars was, of course, facilitated by the RBI’s then apparent policy of holding the rupee. Domestic firms were, in effect, given a huge, albeit implicit, subsidy: they could pocket the difference between domestic interest rates and those in dollars without suffering any losses from rupee depreciation, which had been (sort of) ruled out by RBI policy. In other words, those borrowing in dollars and investing in rupee assets were given a one-way bet—a free lunch.
The muddling though strategy was, let us face it, a bit of a mess: monetary policy tightening (the required response for overheating) sowed the seeds of its own ineffectiveness by fueling further capital inflows. And it is not clear whether the RBI would have been very successful in addressing inflationary pressures, nor in keeping the currency competitive because India was getting the real appreciation anyway--not through the nominal rate rising but via higher inflation.
The problem can be summarized simply as the RBI wanting to meet two objectives—containing inflation and maintaining a competitive currency—but having only one instrument--namely monetary policy. Compounding the problem, of course, was the fact that whereas monetary policy can meet a nominal objective (inflation), its efficacy in meeting the real objective (the level of the rupee) is limited, at least over longer horizons.
Apart from its inefficiency, the policy also had collateral costs. The mirror image of the subsidization of foreign borrowing by domestic corporates was a large fiscal cost, arising from the fact that the RBI bonds used to mop up the liquidity carried higher interest rates than the return earned on the RBI’s foreign assets. A very rough estimate of the annual subsidy/quasi-fiscal cost would be about Rs.3000 crores—the freebie to the private sector--which can be calculated roughly as 3.5 percent (the interest differential between dollar and rupee assets) times say about $22 billion (the ECB limit) in annual interest-sensitive flows.
The muddling-through policy is, for now, history. The primacy of fighting inflation has been asserted, and implicitly, the currency objective has been subordinated or abandoned.
The good news is that this policy is clearly an improvement on the old one. In a number of respects. Monetary policy can now focus on containing inflation. Second, with the currency appreciating, there should be a dampener on further capital inflows because the more the rupee appreciates the more likely the prospect of a rupee depreciation in the future. And any expectation of future depreciation makes borrowing in dollars and investing in rupees less attractive.
But there is bad news: the currency is appreciating, potentially undermining the competitiveness of tradable goods producers—not just exporters but also domestic manufacturers competing with imports--and hence slowing down India’s remarkable growth engine. The RBI is being attacked for neglecting the currency objective. But this is unfair because it does not have multiple instruments for the multiple objectives.
My rash prediction about the impermanence of the new policy is based on a simple fact. If India grows at anywhere between 7-10 percent in the medium run, it will be a sizable net importer of capital flows. The pressures on the currency to appreciate will be inevitable. They will be huge. As the rupee climbs to 38.. 35…30, will it continue to be an object of benign neglect? At some stage, the currency objective will re-assert itself, demanding action. It is not a question of if, but when.
Some are now criticizing the RBI and calling for reverting to the previous policy, wistfully invoking the successful experience of the last say 5-10 years. Yes, exchange rate policy was superbly successful in the past. But, alas we cannot revert to it. Two fundamental differences with the past preclude this. First, in the past, capital inflows were much smaller, which meant that sterilized intervention could be sustained for longer periods of time. Second, any liquidity expansion from capital flows put less pressure on prices because India had more slack, especially in relation to the supply of skilled labor, which India has begun to use so intensively. Today, sterilization quickly leads to the tail wagging the dog, and liquidity expansions from capital flows run up against capacity bottlenecks on the supply side.
It is perhaps one of the undetected virtues of the new policy that it has made transparent the problem posed by a surge in capital inflows, namely the attendant pressures on the exchange rate to appreciate—explicitly through a nominal appreciation rather than surreptitiously via higher inflation.
That exchange rates are crucial for economic development is becoming undeniable. Foreign capital creates a dilemma. What should the policy response be? The past is not, in this instance, the best guide to the future because the world is unrecognizably different. Stay tuned.