The Rupee

Some observations on RBI's exchange rate management

I used to teach International Finance to CFA students in the late 1990s. Those days, the main question which would come up in the class was whether the rupee would plunge, (as it did in Asia, during the Asian currency crisis) if we had less restrictions on capital flows. Those were the days when the prospects for the Indian economy in general and the Indian IT industry in particular were not that firmly established. Neither had growth rates picked up nor had companies like Infosys and TCS reached anywhere near today’s scale. The general feeling we had was that the country had been saved by the lethargy of our policy makers (articulated in as many words by the famous economist, Paul Krugman, who was then on a visit to India). Several rounds of discussions had not built up political consensus about the need for capital account convertibility. As a result, decisions were postponed time and again. This benefited the country as the rupee held its own even as the South Korean Won and the Indonesian Rupiah plunged as did the Malaysian Ringitt and the Philippine Peso during 1997-98.

In general, the Reserve Bank of India (RBI), has been comfortable maintaining the rupee in a narrow band. Notwithstanding its pretensions, RBI likes to micromanage and dole out directives/instructions one after the other to market participants. Now, however, there are signs of change. Since March 2007, RBI intervention seems to have decreased and the currency has appreciated by 10% in the last 4 months or so. One reason for this trend is that the RBI feels rupee appreciation, by making imports cheaper would help control inflation. That way the RBI will not have to raise interest rates again. Remember earlier interest rate hikes created turmoil in our mortgage market. But another unsaid explanation is that a central bank, especially in an emerging economy like India, is under less psychological pressure when the currency is appreciating compared to when it is falling.

Meanwhile, intervention does involve costs. Rupees have to be sold and dollars bought. These dollars have to be invested in risk free instruments. The risk free interest rate on dollar assets is currently about 3% less than that on rupee assets. But as well known economist Surjit Bhalla recently mentioned in a Business Standard article, this cost is not all that high as it is made out to be. The amount in the currency stabilization scheme is currently around $ 22 billion or Rs. 88,000 crores. The loss due to lower interest costs on dollar assets is only around $ 660 million or Rs. 2600 crores, fairly small for an economy of our size.

Bhalla further argues that the Asian countries from Japan to China have all prospered and grown by keeping their currencies undervalued. His research reveals that on a long term basis, each 10% initial undervaluation of a currency allows the country to gain an extra 0.2% growth per annum.

Bhalla’s argument is well taken. But I would argue that an even better course of action is not to spend too much time arguing about what is the “correct” exchange rate or what is the “correct” policy. Corporates should be competitive even when the currency appreciates. The Germans and the Japanese are good examples. Take Japan. The Yen was fixed at 360 to the dollar till 1971. It touched 80 in 1995. Yet Japanese companies like Toyota did not lose their competitiveness. That is because they worked hard, when the currency was undervalued and made their operations learner and meaner. They also invested in overseas manufacturing facilities to insulate themselves from the fluctuation of the Yen.

Indeed, keeping the currency undervalued amounts effectively to the infant industry argument, a hot topic for discussion a couple of decades back. An infant industry must be protected by tariffs. But after it grows into an adult, the protection must be withdrawn. Alas, many of our infants protected by the license raj and import restrictions did not show any strong desire, leave alone capability, to grow. Only after 1991, when the economy started to open up and competition increased, the men were separated from the boys. Similarly, if we allow the rupee to find its own level and if there is some appreciation, the better companies will come up with innovative solutions.

And in any case, it is wrong to assume that the rupee will continue to appreciate. Currently we are on a high, thanks to the IT and BPO industries. But there are serious structural problems underlying our economy. These include the poor education system, pathetic infrastructure, lack of innovation and a very weak political leadership. As our economy comes under the closer scrutiny of more and more foreign investors, we can expect these problems to receive as much attention as the stellar performance of blue chip companies like Infosys and TCS. Then our third world inadequacies will be factored along with our first world capabilities by the markets while valuing the currency. After all, the foreign exchange rate is not so much about interest rates and inflation as it is about the bets people are making on the country’s future.