From Business World of 19 April. India's foreign exchange reserves began to rise; to prevent that, Governor Bimal Jalan began to appreciate the Rupee. I warned him against doing so.
Do not resume this folly
The sudden appreciation of the Rupee in the first week of
April caused jubilation amongst the fecund tribe of appreciationists. Faced by
the inexorable rise in the Rupee, Bimal Jalan had started appreciating the Rupee.
His successor, Y Venugopal Reddy, did not steer the Rupee in any particular
direction, and continued wavering long enough to give everyone a signal that
the policy of appreciation was history. But then suddenly two weeks ago the
Rupee went sharply up again, from Rs 45.50 to Rs 43.50 to a dollar;
appreciationists thought that wisdom had dawned on Reddy at last.
Appreciationists are rather pure
believers in the free market. Intervention in markets is wrong; let them alone,
and let the Rupee go where it would. When reserve inflow is so strong, the
Rupee can be kept down only if money supply is allowed to rise uncontrolled or
government borrows to suck money out of the economy. Deepak Lal and Suman Bery
made some calculations of how much richer India would have been if it had not
sterilized inflows. Vijay Joshi showed in a recent Economic and Political
Weekly that theirs was a gross overestimate and that the loss of growth is
more in the range of 0.1-0.2 per cent a year. The stimulus to growth from
depreciation would far outweigh this loss.
The preference for free markets
cannot apply to the exchange rate because the case for free markets cannot be
carried over to a second-best situation. If all markets were perfect,
frictionless and instantaneous in adjustment, it would make sense to free the
exchange rate as well. But in equilibrium, the rate of appreciation plus the
domestic interest rate must equal the interest rate abroad. If this equality
does not obtain, appreciation will lead to destabilizing capital flows.
While Jalan appreciated the
Rupee, the domestic interest rates did not come down below those in the US.
Hence it became profitable to lend money to India. An investor could send money
to India, invest in a government bond at 6 per cent, and take it back a year
later. If the Rupee appreciated 8 per cent in the year, he got a total return
of 14 per cent in dollar terms – whereas in the US he would have got 2 per cent
on a Treasury Bond. And the more money came in to take advantage of the
inconsistency between the exchange rate and the interest rates, the more would
reserves go up, and the greater the incentive to appreciate the Rupee. So there
will be spiraling appreciation. When it finally stops, all the hot money will
fly out, and we will have another payments crisis.
Dr Reddy understands this; so he
abandoned the policy of appreciation he had inherited. The reason for the blip
of appreciation at the beginning of April was that Reserve Bank knew it was
transient. It was probably foreign subscriptions to the ONGC public issue. And
in that week, RBI made net purchases of $3.37 billion.
However, he has a minister
watching over him from Delhi. This minister’s understanding is less perfect; he
may get sold on the idea that markets should be left free and the Rupee allowed
to appreciate. Could Dr Reddy resist the pressure from Delhi? Not for long.
What should he do then? He should abolish NRI deposits; with such bulging
reserves, we do not need to give NRIs expensive sops; and if they go to greener
pastures, our reserves will come down to $70 billion. And if he must
appreciate, he should make a big appreciation – say, to Rs 30 a dollar. If the
appreciation is big enough, people will stop expecting further appreciation, at
least for some time, and the speculative capital inflows will stop.
Appreciation is bad; but
creeping, predictable appreciation is far worse – just like creeping
depreciation. India’s creeping depreciation broke down and led to the crisis of
1991; its creeping appreciation of 2002 was equally dangerous, but did not last
long enough to do major damage. If dogmatic free marketers are in power,
appreciation cannot be prevented. But even they should be able to see the folly
of creeping, predictable appreciation which takes the risk out of speculating
on the Rupee’s rise.
