Saturday, January 19, 2008

More on the Rupee

There still isn't a consensus on the ideal future course for Indian currency policy. Today, Surjit Bhalla in the Business Standard laments the adverse impact of the rupee appreciation on the economy-wide growth figures in general and the Indian exports in particular. Though this might be true to some extent, we can actually do something about it only if the following conditions hold
However, both these statements are untrue. The central bank has actually been struggling hard to keep the rupee down over the last year with limited success. Thus, the rise in the rupee has been despite the RBI policy and not because of it.

In the wake of huge capital inflows, the RBI typically undertakes large-scale purchases of US Dollars in the currency market to keep the rupee down. However, currency market intervention inevitably leads to increases in liquidity and acceleration in prices. To suck the excess liquidity out of the system, the RBI sterilizes its intervention by issuing government bonds. But sterilization is no magic wand. Large scale sale of government securities increases interest rates and tightens credit conditions. Moreover, the interest payable on these bonds constitutes an enormous burden on the exchequer.

The RBI's experience in Dec 2006-Mar 2007 clearly illustrated the problems created by the weak-rupee policy. Call rates shot up to astronomic levels. To bring them down, the RBI resorted to partial sterilization which resulted in an inflation scare. Eventually, the RBI had to ease its dollar purchases and let the rupee appreciate in order to retain some semblance of control on inflation and the credit conditions.

As Milton Friedman once quipped, there is no such thing as a free lunch. The cost of pursuing a weak rupee policy, amidst strong global pressures, is enormous. Successful pegging of the exchange rate will either entail the loss of monetary policy independence or the imposition of draconian capital controls. Neither of the outcomes is desirable or viable.

Instead of trying to have a currency policy, the RBI should be focusing on setting up a vibrant currency derivatives market that will mitigate some of the distress caused by a free-float exchange rate regime.


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