The recent weeks have seen the rupee rising against the dollar amidst squeals of protest by exporters of textiles and other manufactured goods, besides services. Software services have, particularly, seen their competitiveness suffer. Importers of goods and services may have benefited because of the decline in the rupee value of goods and services imported. But this can lead to protests by competing Indian manufacturers located in India. The Government has responded somewh at reluctantly by offering a package of tax incentive and interest reductions to exporters. While these steps are, no doubt, welcome, they are not as easy to effect competitiveness as exchange rate intervention resulting in a devalued rupee. Not for nothing is China resisting the US pressures for revaluation of its currency.
The RBI is caught on the horns of a dilemma. It stopped aggressive intervention in the currency market because of the adverse effects noticed as a result of its injection of liquidity by sale of rupees in exchange for forex. The supply of excess domestic currency leads to inflationary pressures unless offset by sterilisation, which means the central bank would have to sell debt paper of Government to the banks to suck out the additional rupees. Unfortunately, sterilisation has its costs. It increases the supply of debt paper leading to a fall in their price, which is the inverse of interest rate.
The net result of successful intervention and sterilisation is rise of interest rates, which, in turn, leads to further capital inflows — a vicious cycle. So, Indian banks return the compliment by countering the effects of sterilisation by investing further in government debt, unlike their Chinese counterparts that cooperate with their central bank in achieving the desired effects of sterilisation. All in all, a messy situation! To counter the inflationary effects of capital flows, the central bank sterilises the flows, which only leads to further capital inflows.
Impact Unclear
The debate between the advocates and opponents of intervention has been long on argumentation, but weak in conclusions.
The latest RBI Report On Currency and Finance devotes considerable space to analyses of research papers on the subject of effectiveness of sterilised intervention. While the technical details are, no doubt, interesting to academics, the policy implications of the debate are not clear. It is not definite whether sterilised intervention does at least succeed in reducing the volatility of the exchange rate, although it has resulted in reducing the monetary impact of the liquidity surge.
While the debate goes on, the adverse effects on manufacturing industries as well as services are, indeed, grave. The sops offered by the Government and the banks are, no doubt, well-motivated. But the market has already discounted their effects. What is material in the export market is the offered price of the products. This remains higher than that of competition’s.
The RBI and the Government will have to have a look at whether their policy options are limited to either intervention or non-intervention. Can the RBI not think of imposing a cap on capital inflows of a particular hot-funds type — a la the response of some Latin American countries? Of course, bourses and businesses may react adversely.
To the extent we depend on capital flows for meeting our current account gap, our position will become more vulnerable. But there has to be a way out of the problem other than that which inevitably results in curtailing our export competitiveness.
Self-Defeating measure
It is, of course, desirable to liberalise capital outflows by Indian residents, but beyond a point, the measure can be self-defeating. The outflows can become a flood. I feel the RBI has its task already well cut out to manage the large capital inflows. If to this we add the problem of capital outflows on an unregulated basis, the RBI’s task will be nightmarish.
Voices have been heard comparing the manner in which Japan faced its problem of appreciation of the yen in the 1990s from nearly 230 yen to a dollar to around 130. Japan did so by improving its productivity and introducing product innovations. This is, of course, a challenge which Indian industry has to wake up to. But that requires a host of other enabling factors. Infrastructure, for instance, is an important bottleneck. But the solution to that problem is difficult and of long gestation, even given the attention at the Prime Minister’s level itself. Apart from this, there is the emerging issue of lack of adequate skilled manpower. This calls for provision of more education and training facilities. The problem of a dearer rupee can be solved only by a multifaceted attack on many fronts. This, of course, requires Government to take action on many aspects.
Ultimately, the RBI can only work with the tools at its disposal within a given global framework and a political environment not of its own choice. To control capital flows — in both directions — is against the current sentiment in favour of capital convertibility. At the same time, allowing capital inflows or outflows unregulated threatens the sustainability of the fiscal stability. The solution may lie in a combination of intervention with fiscal action to support or manage the price of essential commodities and at the same time encourage exports by tax sops. Obviously, this is precisely the blend the authorities have served up now.
A more sophisticated approach is, however, not beyond the capacity of the whiz kids of Mint Street and North Block to evolve. The price may be higher in terms of fiscal deficit, but one cannot obviously have exchange rate stability, low inflation and fiscal responsibility at the same time. This is the classic trilemma of monetary fiscal management in another form.
Too Complex?
In this context, I recall a reference to the exchange rate of the rupee in Oscar Wilde’s Importance of Being Ernest. In the play, the elderly governess advises her ward to lay aside the chapter on the Indian rupee as it is too complex. That discussion obviously referred to a time when the richer classes of Great Britain were worried about the value of their Indian stocks, which was denominated in rupees. Their fear at the time was of the rupee depreciating against the sterling. Now, the tables are turned; the rupee is appreciating. An Oscar Wilde of today will be well-justified in repeating the warning that the rupee’s gyrations are, indeed, too complex to understand, but in a different direction.
The RBI Governor and the Finance Minister have to fight with the harsh reality of economic and political life. “The unpleasant consequences of a bulge in the resources flow on the capital account are easily appreciated;” the disease is easy to diagnose.
The appreciation of the causes of appreciation of the rupee is good so far as the diagnosis goes. The problem is how to cure the disease — of abundance of riches — without hurting the patient — the Indian industry and the economy. Both North Block and Mint Street have to work together to solve this trilemma.
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