Exchange Rate Management: An Emerging Consensus?- Part II
Speech of Dr. Bimal Jalan, Governor, Reserve Bank of India delivered on the 14th August 2003, at the 14th National Assembly of Forex Association of India in Mumbai.
21. On the whole, it is likely that external flows into India have been motivated by factors other than pure arbitrage. Figures on sources of reserve accretion available upto the end of last year (2002-03) confirm this view. It is also pertinent to note that domestic interest rates among industrial countries also vary considerably. For example, in Japan, they are close to zero. In the U.K., they are above 4 per cent, and in the U.S. about 1.5 per cent. There is no evidence that capital has been moving out of U.S. to U.K. or Europe merely on account of interest differential. Within a certain low range, capital flows are likely to be more influenced by outlook for growth and inflation than pure arbitrage even among industrial countries with full CAC.
22. Another point which has been forcefully put forward by several experts in the context of rising reserves, is that India should use its reserves for increasing investment for further development of the country rather than keep them as liquid assets. It is argued that it is paradoxical for a developing country to have a current and capital account surplus, and thereby add to its reserves, rather than use foreign savings to enhance the rate of investment in the economy.
23. In principle, this point is valid. There is no doubt that in our present situation, maximum support has to be given to increasing the level of investment, particularly in the infrastructure sector. It is for this reason that RBI in the recent period has been following a soft interest rate policy in an environment of low inflation. However, at the same time, it must be emphasized that there is very little that RBI, (or, for that matter, Government) can directly do to use additional reserves for investment. The equivalent rupee resources have already been released by the RBI to recipients of foreign exchange, and equivalent rupee liquidity has already been created. The decision on whether to invest, consume or deposit these additional rupee resources lies with recipients, and not with the RBI. By all means, let us urge them to invest, but there is not much of a case for pointing a finger at additional reserves as a "cause" of lower than desirable level of investment activity in the economy.
24. Let me now come to my last point, which is of considerable present-day interest in India in the context of high and rising reserves, easy liquidity, low interest rates and the weakening dollar, i.e., what should be the correct or right policy stance for the management of exchange rate in India in the present environment? In RBIís periodic credit policy statements, as well as other public statements, RBI has highlighted the main pillars of its strategy for the management of the exchange rate. These are: RBI does not have a fixed "target" for the exchange rate which it tries to defend or pursue over time; RBI is prepared to intervene in the market to dampen excessive volatility as and when necessary; RBIís purchases or sales of foreign currency are undertaken through a number of banks and are generally discreete and smooth; and market operations and exchange rate movement should, in principle, be transaction-oriented rather than purely speculative in nature.
25. It is perhaps fair to say that the actual results of the exchange rate policy followed by the RBI, since the Asian crisis in particular, have been highly positive so far. In addition to sharp increase in reserves and generally "orderly" movements in exchange rates with lower volatility, the confidence level of domestic and foreign investors in the Indian external sector policies is strong. Indiaís policies have also been described by the IMF as being "comparable to the global best practices" in a recent study of 20 select industrial and developing countries. Interestingly, a leading global news agency, in an international journal, has recently described Indiaís currency model as being "ideal" for Asia. India is now one of the very few developing countries which has set up its own clearing house for dollar-rupee transaction with the concurrence of the Federal Reserve System, New York.
26. In the last few months, however, when the dollar has been depreciating against major currencies, and rupee has been appreciating against the dollar (albeit slowly), a number of suggestions have been made by experts and others calling for a shift in RBIís exchange rate policies. There are, in the main, three alternative approaches that have been suggested for consideration:
One view advanced by several distinguished economists, including Prof. Kenneth Rogoff of IMF during his recent visit to India, is that rupee should be allowed to appreciate freely in line with market trends. According to this view, there is no strong case for RBIís further intervention as reserves are already very high. RBIís purchases create substantial additional domestic liquidity, which may be destabilising in the long run. There is also no evidence, in their opinion, that unconstrained appreciation or volatility would affect growth prospects or lead to any other macro-economic problem.
An exactly opposite view, which, among others, has been recently articulated by an important all-India industry association, is that RBI should intervene more aggressively in the market to further reduce the degree of appreciation. The main argument in favour of this view is that India must maintain its global "competitiveness", particularly in relation to China which has a fixed exchange rate with the dollar and whose currency has been depreciating along with it.
A third view, which has been recently put forward by a leading economic journal, among others, is that RBI should pursue what it has referred to as a policy of "calculated volatility". It has been argued that the present policy of controlled volatility has provided virtually risk-less gain to market participants since the rupee has been expected to appreciate substantially and continuously over the past few months. According to this view, in order to prevent excessive capital inflows during this period, RBI should have allowed the exchange rate to "overshoot" quickly the targeted exchange rate of, say, Rs.46.20 (or any other number) to, say, Rs.45.50. Thereafter, it should have allowed the rupee to depreciate slowly, but not necessarily smoothly, to the above targeted number over a period of next few months. In essence, this proposal is akin to a policy of (announced or unannounced) fixed exchange rate within a wider band.
27. The RBI welcomes the current debate. Reserves, at present, are certainly at a level which is more than enough to meet any foreseeable contingency. It is also clear that, in the present period, capital inflows and remittances have been strong, requiring continuous domestic liquidity management. In principle, therefore, it would be nice if an alternative viable exchange rate management system could be put in place which would avoid excessive build-up of reserves and domestic liquidity and, at the same time, maintain Indiaís external competitiveness with low inflation and low interest rates.
28. In theory, each of the above alternative approaches has some merit. However, it is not entirely clear that they can be put into practice without causing substantial instability or uncertainty and possible emergence of macro-economic problems which are worse than what they are trying to solve. An implicit assumption in two of the above alternatives is that there is a level at which, after initial fast appreciation, the exchange rate will either stabilise or turn around. A further implicit assumption is that the level (whatever it is) is either already known or will become known to the market as it is approached.
29. RBIís past experience does not suggest that these assumptions are valid. It would be recalled that there have been periods when rupee exchange rates have been relatively more volatile and movements have been sharper. However, during periods of sharper appreciation, instead of inflows declining and demand for foreign currency rising, it was noticed that actual market behaviour was the opposite. The opposite was true during periods of sharp depreciation. Exchange rate expectations had their own momentum and were often self-fulfilling. There must, of course, be a level where these expectations will reverse. However, if that level, because of "momentum" trading in imperfect and thin markets happens to be significantly out of line with "fundamentals", considerable instability and substantial overvaluation (or under valuation) may result. Such an outcome may do more harm than good to continued confidence in a countryís exchange rate system.
30. The third suggestion to hold the rates at current levels, and not to allow it to appreciate any further, even if inflows are strong, is also likely to be unsustainable over any length of time. It virtually amounts to adopting a "fixed" or a near-fixed exchange rate system with a floor. Past experience suggests that this system can work well, as it did in East Asia prior to the crisis, when the economy is doing well and inflows are strong, but it comes under extreme pressure when there are unfavourable domestic or external developments. Abandonment of a system of "fixed" exchange rates (or a system with a known floor) then becomes unavoidable. Such a change, when it occurs under pressure, can result in considerable instability which is likely to be spread over a fairly long period. At the end of this process, the country then has no option but to revert to a more flexible exchange rate system.
31. It is by no means a mere coincidence that all countries affected by external crises in the 1990s had a fixed or near-fixed exchange rate systems. China at present is an exception to the rule in view of its persistent trade surpluses over a long period combined with very high levels of foreign direct investment. It is not certain how long into the future this situation will prevail. In any case, Chinaís special characteristics are difficult to replicate in other emerging markets with lower volume of trade and foreign investment.
32. The desirability of maintaining the-overall competitiveness of an economy can hardly be questioned. However, the long-run competitiveness of an economy needs to be measured in relation to a multiple currency basket, and in relation to major trading partners over a reasonably long period of time. Exchange rate fluctuations among major currencies are now an everyday fact of life, and it is important for all entities with foreign exchange exposures to resort to "hedging" with appropriate risk management of assets and liabilities.
33. On balance, the benefits of the suggested alternatives to the present system are not very clear. The present system is by no means an ideal one. However, like the old cliche about virtues of democracy, it is probably better in the long run than all the available alternatives. In view of behavioural and market complexities in this area, as well as multiple economic policy objectives, solutions which seem "ex ante" optimal may turn out to be disastrous "ex post" - after the event Ė as happened in Argentina recently and East Asia and Mexico some years ago.
34. Nevertheless, as I said a while ago, RBI welcomes the present debate. As a contribution to this debate, I have tried to deal with some relevant issues, and indicate our present views on them. These views are, of course, subject to change in the light of domestic and international experience and further academic insights.
35. We look forward to your deliberations and hope to benefit from them.
Click here for "Part I" of the speech