The nominal dollar-rupee exchange rate has been under pressure in recent weeks. India Inc has fired all cylinders, to force the authorities to stem the depreciation of the rupee.

There is need to reflect on the fundamentals of exchange rate formation. A basic axiom is that if inflation in country A is higher relative to country B, country A has to depreciate its currency by the extent of the inflation rate differential.

Importers root for an exchange rate appreciation while exporters advocate depreciation. The forex reserves represent the ammunition to smoothen out excessive swings in the exchange rate. In the case of India, the reserves are entirely built up by capital inflows. India is the only leading emerging market economy (EME) in Asia that has a persistent balance of payments current account deficit (CAD). Hence, the Indian forex reserves are vulnerable to the caprice of volatile capital movements.

RBI's policy shift

Until 1997, the Reserve Bank of India used the trade weighted six-country Real Effective Exchange Rate (REER) as a pole star. This was an index of the nominal exchange rate adjusted for inflation rate differentials. Since 1997, the RBI's deity continued to be the six- country REER, except that the deity was no longer on public display.

The RBI progressively moved over to a hands-off exchange rate policy and the emphasis was on controlling “volatility”. For years the RBI accepted the need for the general theory of the second best wherein it tried to come as close as possible to the Impossible Trinity of an independent monetary policy, freer capital flows and a managed exchange rate.

Forex reserves were built up during periods of heavy capital inflows to prevent excessive appreciation and utilised to prevent excessive depreciation of the rupee. This was the policy up to the latter part of 2008.

In the more recent episode of exchange rate fluctuations, the RBI renounced its policy of buying up forex during periods of heavy capital inflows and the REER appreciated by 19 per cent by July 2011 on the basis of the six-country index.

Having renounced buying while the rupee was appreciating it should have renounced selling when the rupee depreciated. Initially, the RBI held on to this very reasonable policy stance, but India Inc launched a massive campaign and the RBI was forced to stem the depreciation of the rupee.

The actual extent of intervention would be known only after some time. A policy of non-intervention, when the rupee appreciates, and intervening when the rupee depreciates is not sustainable as, sooner or later, India would run out of forex reserves.

The delightfully vague policy of “controlling volatility” takes away a reference point not only for the markets but, more importantly, the RBI no longer has a clear reference for turning points in its exchange rate management.

Another way of assessing an appropriate exchange rate is to use the March 1993 base, when the dual exchange rates were merged and the market stabilised for a long period at $1= Rs 31.37 even though the RBI was buying forex over an extended period. Using this nominal exchange rate and a secular inflation rate differential of 5 per cent, between the US and India, the appropriate nominal exchange should be $ 1= Rs 63. Intervening at the present rate of around $ 1= Rs 52 would only dissipate the forex reserves.

What the RBI needs to do is to sit back and let the rupee depreciate a little.

Importance of gold

Another important issue is the composition of the forex reserves. Countries have nowhere to hide as all reserve currencies are suspect. A multi-polar reserve currency system, advocated by a number of eminent experts, is a pipe dream. Such a system is bound to fail as it is a summation of the weaknesses of a number of reserve currencies.

The international monetary system is condemned to massive instability as it stubbornly clings on to the reserve currency concept. Sooner or later, the international monetary system will have to give up the illusory reserve currency system and revert to a gold-linked international monetary order. While we continue to denigrate the gold bugs, the resurgence of gold is inevitable.

Emerging market economies need to gradually increase the gold proportion in their total forex reserves. Those opposed to such a policy argue that gold prices are notoriously volatile. The critics of gold need to realise that a Chartist's approach to gold prices is inappropriate.

No major central bank intends to sell gold in the ensuing period and as underground stocks of gold are rapidly dwindling, there is no way that gold prices can crash to the levels of the 1980s. Fiat currency carries with it stupendous risks. Despite all the intellectual backing for a multi-polar reserve currency system, the basic flaw of such a system cannot be wished away. Emerging market economies, including India, should not be deaf to the death knell of the reserve currency system and they would do well to gradually increase the proportion of gold in their forex reserves.

(The author is an economist. >blfeedback@thehindu.co.in )

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