Exchange Rate Management: Reassuring Politics, Reasonable Economics
by Arvind Subramanian, Peterson Institute for International Economics
Op-ed in the Business Standard, New Delhi
July 27, 2007
© Business Standard
Exchange rate management and capital account opening may seem an unlikely prism to view the workings of the Indian political system. So, before assessing the economics of the recent policy changes, stop and focus on the politics, and you will find cause to celebrate the spectacle: different actors pushing their interests; vigorous and open debate among them and others; and decision making that reflects and reconciles competing claims and shows capacity for learning based on experience. To Oscar Wilde’s prudish governess, who famously counseled her ward to omit the chapter on the rupee, the response would have to be: Do so and your understanding of political economy will be poorer for it.
Economic outcomes in pluralist societies arise from the interaction of different interest groups and institutions. Take the actors in this saga of the rupee each with distinct but legitimate objectives: the Reserve Bank of India (RBI) which is concerned with preserving monetary autonomy; the Commerce Ministry which has to be mindful of the interests of exporters; the Finance Ministry which is keen to promote financial efficiency and integration but is also acutely sensitive to safeguarding the public finances; and finally, the Economic Advisory Council (EAC) to the Prime Minister, which presumably takes a broader view, aggregating and weighting the interests of each of these actors.
How did the process play itself out? The saga unfolds in three acts.
In act one, we had the RBI that, partly out of policy decisions to liberalize the capital account, especially for external commercial borrowings (ECBs) found itself in the unenviable situation of struggling to preserve monetary autonomy; the autonomy it needed to combat what seemed then (around April) like incipient but potentially damaging inflationary pressures. It responded by letting the exchange rate go, and the rupee quickly appreciated by about 10 percent.
The consequences were predictable and predicted. The resulting appreciation led to a clamor for help from exporters. A spate of studies also started to suggest that the Indian growth machine would slow down because of the appreciation. So, in act two, the Commerce Ministry, announced a package of financial assistance—comprising duty drawbacks and cheap credit—amounting to Rs.1400 crores.
While the budgetary consequences of this package are not immediately large or fiscally fatal (less than 0.1 percent of GDP), it must nevertheless have been discomforting to the Finance Ministry—especially if the package were to set a precedent for future episodes of appreciation—which is justifiably keen to reassure a skeptical world that its stated fiscal targets will be met. The Finance Ministry has probably also come to recognize the tension between its objectives of furthering financial integration and maintaining fiscal prudence: Increased capital inflows inevitably entail additional fiscal costs either in the form of sterilization (to prevent appreciation) or explicit assistance to exporters (to address appreciation). Thus, in act three, the EAC recommended that the government should clamp down on ECBs, thereby trying to head off some of the future pressures for rupee appreciation.
The EAC’s intervention has been especially noteworthy as a contrast to the recent Ministry Report, which made a strong ideological case, with little empirical substantiation, for faster capital account convertibility. The EAC’s advice, on the other hand, seems to have been sensitive to the experience of the last few months, demonstrating the system’s capacity for learning by doing and, indeed, learning from overdoing.
Consider next the economics of the different policy changes. Under current conditions of dwindling ability to influence the exchange rate, the EAC’s recommendation of limiting ECBs, without damaging market confidence, is the most appropriate policy response. I argued in a recent paper in Economic and Political Weekly that inflows of foreign capital are a double-edged sword (http://www.epw.org.in/epw/uploads/articles/10751.pdf). India can, at this stage of its development and given the considerable tightness in skilled labor markets, forgo the efficiency gains from capital inflows for averting costly real exchange rate appreciation. For this reason, the other vestige of policy influence over capital flows—limiting foreign flows into domestic bond markets—should also be preserved for the time being.
Assistance to exporters in the form of duty drawbacks is an inferior response to declining competitiveness: Drawbacks provide relief only to some (mainly manufacturing) exporters; the magnitude of relief is arbitrary and perverse (the more a sector buys imported intermediate inputs, the more relief it gets); import-competing industries get no assistance; and drawbacks give rise to administrative costs and opportunities for rent seeking and evasion. One hopes the assistance will be implemented consistent with India’s World Trade Organization (WTO) obligations. If that is the case, and given the relatively modest magnitude of the relief, it can be viewed as a small cost, perhaps even a necessary political concession to forestall demands for more damaging policy actions.
Monetary and exchange rate policy, however, deserves special mention. This policy has mutated three times in three months. First we had exchange market intervention combined with large scale sterilization; this was followed by a brief period of a free float; and now in the third phase, the RBI has reverted to exchange intervention but without sterilization. The consequence has been an explosion in liquidity, with the call rate at nearly zero percent, which is likely to stoke goods and asset price inflation down the road. Moreover, for an economy growing at close to 10 percent, a near zero percent reference interest rate seems unusually low and unsustainable; indeed, some recent inflows are clearly speculative, anticipating that current rupee fixity and monetary laxity will give way again to future appreciation.
It is imperative now for monetary policy to acquire greater predictability. The difficulties should not be underestimated because the RBI is juggling multiple objectives with limited policy levers—all the more reason not to further deplete the RBI’s arsenal by pushing capital account convertibility. Even so, moving between three monetary policy regimes within such a short period, with call rates oscillating between 60 percent and zero percent, cannot be good for engendering market confidence.
On the whole, though, policy making in this recent episode of capital flows and rupee appreciation has been reassuring, even impressive, to watch. But one price of economic success, of being an attractive destination for capital, is the near certainty that more rupee-related turbulence lies ahead.