MAVERICK VIEW. Enough of this exchange rate machismo

In the present global economic scenario, large capital inflows are inevitably followed by large capital outflows which can be destabilising, particularly in the case of the emerging market economies (EMEs).

Countries that follow imprudent and inconsistent macroeconomic policies are punished as the external sector comes under pressure. In such a scenario a country cannot be too careful in its external sector management.

India’s international assets in June 2014 amounted to $493 billion while the liabilities were $839 billion resulting in a net indebtedness of $347 billion (as against $313 billion in June 2013). Of India’s liabilities, about 30 per cent relate to direct investment and 24 per cent is portfolio investment. Of the country’s liabilities, 46 per cent is non-debt and 54 per cent is debt liabilities.

External debt as of June 2014 amounted to $450 billion. On a residual maturity basis, the short-term debt (up to one year) was 39 per cent of total external debt, equivalent to 55 per cent of the forex reserves.

The ratio of foreign exchange reserves to total external debt, which was over 100 per cent during the period 2004-2010, is now down to 70 per cent. While the situation at present is still comfortable it is essential that Indian policymakers use early warning signals of deterioration of the external sector and undertake timely corrective action. In particular, the short-term debt needs close monitoring.

The balance of payments current account deficit (CAD), which in 2012-13 reached a critical level of 4.7 per cent of GDP, shrank to less than 2 per cent in 2013-14 largely due to the gold import policy which resulted in a reduction in official gold imports but a quantum jump in illicit imports of gold. Again, the slowdown in the growth rate slowed imports. With the revival of growth there will be a surge in imports. Hence, there is a need to avoid excessive euphoria on the low CAD.

In today’s integrated global economy, each country’s domestic and external sector policies should be in sync. A high rate of growth, a low CAD, a strong exchange rate and low interest rates despite an inflation rate higher than in major industrial countries, apart from a high fiscal deficit, reflect policy inconsistencies, resulting in punishment by global markets.

If we try for a rate of growth higher than what is sustainable, given the savings rate, the CAD will widen, and the cost of financing the CAD will go up. Indian interest rates are too low and given the inflation rate differentials, lower rates will only result in a capital outflow.

Thus, before we desire lower nominal rates of interest, we have to get down the medium-term inflation rate. There is a strong rationale in the Reserve Bank of India not yielding to the clamour for lower interest rates. A strong exchange rate, low inflation and low interest rates cannot be merely desired, they have to be earned.

Using the six-country trade weighted Real Effective Exchange Rate (REER) (2004-05=100) , the rupee is overvalued by 17 per cent. Despite the US dollar strengthening, the macho spirits do not accept a depreciation of the nominal US dollar-rupee exchange rate from present $1=₹61-62. This is very dangerous. With large capital inflows in the recent period, there was a need to aggressively build up the forex reserves and let the rupee depreciate. In the absence of such a build-up of reserves, the country will be vulnerable when capital flows reverse.

In the first half of the 1990s, the RBI used REER as the pole star for the exchange rate. Thereafter, there was less emphasis on REER and greater emphasis on the role of the RBI in controlling volatility.

There is the well-known ‘impossible trinity’ of an open capital account, an independent monetary policy and a managed exchange rate. Logically, one of these three has to give way.

But in the Indian case we do not have a fully open capital account, nor do we have a fully independent monetary policy; thus, there is merit in having some exchange rate objective. One could use some sort of a General Theory of the Second Best under which we have a reasonably open capital account, a modicum of independence in monetary policy and intervention by RBI in the forex market in tune with some objectives.

While the RBI has been apprehensive of a pre-committed REER, the RBI could endeavour to base its forex intervention on some broad parameters such as inflation rate/interest rate differentials and also respond to waves of capital inflows and outflows. One hopes that Governor Raghuram Rajan will soon enunciate the philosophy of RBI’s exchange rate policy.

Inflation rate differentials between India and major industrial countries in the recent period warranted a depreciation of the nominal rupee exchange rate vis-à-vis the dollar. Many influential opinion-makers, including Shankar Acharya. AV Rajwade and Abheek Barua, have concluded that the rupee is overvalued.

My own rather elementary tracking of the secular inflation rate since 1993 (the year of unification of the dual exchange rates) warrants that the current exchange rate of the rupee should be well over $1=₹70. But such an exchange rate would erroneously indict the authorities for failure of macroeconomic policy. There is, therefore, a need to sensitise opinion-makers, analysts, bureaucrats and, above all, political honchos that an overvalued exchange rate will extract a heavy price in terms of an unsustainable CAD, and ruin micro, small and medium industry, which is, by and large, export intensive. Under an overvalued exchange rate policy we beggar ourselves and enrich our trading partners.

The writer is a Mumbai-based economist