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V. Kumaraswamy

TILL more than a decade back, the RBI followed a policy of maintaining the value of rupee against a basket of currencies; this, of course, was never disclosed.

Some analysts had, however, back-worked the basket and arrived at a reasonably accurate composition. Things have been more open since 1993. The central bank has more or less maintained the value according to the dictates of the real effective exchange rate — REER, for short. Things have been working reasonably well. At least, till recently.

The recent surge of reserves and the rupee-value cannot all be due to the policy. Much of the surge occurred because of depreciation of the dollar against other currencies, inflow of deposits due to high interest rates prevailing in India vis-à-vis Libor, etc., even on an adjusted basis.

And the theorists say `have your assets in appreciating currency'; as the rupee is appreciating, money parked outside have started coming home. And the liberalisation on inflows of debt and exports has been far greater than the corresponding steps on repayment or imports. All these have combined to produce a heady feeling of an appreciating rupee.

But it is time to take stock. To see if the policy of maintaining the value of the rupee based on adjustments linked to inflation differentials is sustainable in the long run. World over, the pegging of currency values to one thing or the other (be it gold, the dollar, pound sterling or a basket of currencies) has ultimately failed. Only the magnitude of the consequences or catastrophes has differed. Subsequently, these pegs have all been dismantled.

REER too is a `peg'

In a way, REER is also a peg. There is nothing `real' about the real rate. It is only with reference to the base year. By continuously adjusting it to the inflation of the host and its trading partners, one is retaining the `bias' of the base year.

It preserves the terms of trade, purchase price parity, and indeed all the anomalies and follies that existed as on that date, as they were. If those were unsustainable, or at an advantage or disadvantage to the host nation or its counterparts, the anomalies will only persist. These tend to distort the trade flows, which slowly accumulate as trade deficits (like in the recent case with Argentina) for the host or as surpluses.

Limitations

In India the REER base year was changed in 1993 as that is when substantial changes were ushered in vis-à-vis the trade account. But that does not mean that purchase and consumption habits change overnight.

As psychological experiments have shown, fish that were prevented from reaching their feed by an intervening transparent glass simply stopped reaching for their feed even when the barrier was removed! Consumption habits and preferences between foreign maal and desi goods change very slowly. The purchase of industrial goods may adjust faster. And there has been substantial liberalisation in trade matters since then.

Second, the competitive advantages of nations do not stay static and are not exactly captured by inflation movements alone.

Third, however much the text-books say that the inflation differential should be equal to the interest rate differential, there are differences in the real world in real interest rates — natural or engineered (as in the case of RIBs and IMDs, which offered abnormally high rates) — and these do impact the exchange flows and rates.

Fourth, and perhaps the most important reason why REER will sooner or later peg out and flounder — at least, in the Indian scenario — is that it is so much away from the purchasing power parity, which has been consistently over 4 (against us).

There is no sustainable reason why a haircut in one Chennai suburb should consistently cost Rs 80 when it costs only Rs 20 in another.

Either the people will move or the hairdressers will. By adjusting it dynamically for inflation on both sides one will only be preserving the 80:20 ratio — that is, sustaining the unsustainable.

Left to float freely, they will converge. But this 80:20 scenario is what our policy-makers are bent upon preserving. Added to this is the pressure of capital inflows, which are in our favour now.

Policy focus

Perhaps the most sustainable `pricing policy for dollars' (to rename exchange rate policy) will be that based on `transaction cost' adjusted PPP. `Transaction costs' here include the transport and insurance costs, costs of inventory, hidden costs of differential controls and restrictions, labour law and other legal rigidities, lax administration and infrastructure, and, of course, the inertia of the people to migrate, or change their consumption habits. Maybe it is time we moved away from managed pegs and managed REERs. Our trade and service earnings are heavily concentrated in five or six sectors. And in these it seems unnecessary to retain the current parities of 4:1 to sustain our cost advantage.

Take, for example, software. Our labour cost advantage is significant and, even if dollar were to fall to half of what it is today, we may still get the same dollar earnings.

It may give a policy focus to work out the target parity for these dollar-raking sectors and keep moving in that direction rather than follow a staid, statistical approach of a 31 or 36 country index, as we are doing now.

(The author works for a large chemical manufacturer-exporter. The views are personal.)

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