In the past, prolonged easy monetary policies in advanced economies have changed the risk premia, resulting in significant switches in capital flows to emerging economies including India. Higher volatility in capital flows resulted in exchange rate volatility and generally had a profound impact on the spectrum of asset and commodity prices. As India has mostly financed its deficit in current account through surplus in the capital account, reversal in easy monetary policy in developed countries increased the pressure on currency and resulted in depletion of the forex reserve with RBI in the aftermath of the crisis.
India experienced large inflows of capital well in excess of its current financing needs (net of capital account and current account balance, as the accompanying chart shows) beginning FY03. For example, in case of India, such flows increased mani fold to an annual average of $47.4 billion during FY03-FY13, reaching a peak of $93.6 billion in FY08. Net capital inflows to India dried out in FY09 ($11 billion) to substantially lower than in FY08. But, in the subsequent years, capital inflow increased. In our case, though FY14 started with a weak economic sentiment with a high current account deficit (FY13 CAD $87.8 billion) and fiscal mismanagement burden, proactive measures to curb gold import has helped to do sufficient adjustment in the current account. In the current scenario, we expect in FY14, India would have a significant excess of foreign capital flow after paying its current account obligations. Thus, it is no wonder that the rupee is currently on the upswing.
What will be RBIs response in such a scenario Well, the first has to be to build up the foreign exchange reserves. Interestingly, Indias foreign exchange reserves had jumped by a cumulative $256 billion during FY03-FY08, with an $111 billion accretion in FY08 alone. Thus, it is not correct to say that there was no accretion. There was however a $58 billion draw-down in FY09 that was almost recouped in FY10-FY11. However, the pace of such accretion could have been faster, since the rupee appreciated during FY11.
Given the limits to foreign exchange reserve accumulation, another option could be to increase gold-holding so as to exploit the safe haven property of the metal and reduce risk on the asset side (as was done by RBI post-crisis). However, this strategy will require foregoing some seignorage. Given that 21% of non-tax revenue comes from RBI profits, it will need some co-ordination with the government. Further sequencing of purchase of the yellow metal will also be determined by the maturity profile of foreign liability outflows in next three years (total 3-year outflows account for over 55% of the total over next 10 years).
However, what is most crucial is the position of China. China has been selling dollars and, in December 2013, sold $47 billion of US treasuries. Since 2010, there have been muted conversations of an overhaul in international monetary arrangements. At the heart of this discussion is a gradual move towards a multi-currency reserve system where the Yuan will have major role to play as Chinas intentions to internationalise its currency are well-known. The contours of such a system and plan of transition are unknown, and plagued by uncertainties (as an example, recently China widened the currency band).
This apart, going by recent events in international finance, there is now a greater uncertainty in the US Feds forward guidance. The frustration arising out of asymmetric policy responses by various central banks were well captured in the recent statements by the Ministry of Finance official at G20 summit and, before that, by the RBI Governor that monetary policy coordination may have broken down. Hence, the coming years may be marred with turbulence in financial and currency markets.
In conclusion, the evidence of the rupees appreciation will clearly be visible at least for now. However, over the medium-term, preparation for a possible currency war situation will require some strategic planning. In the short-term, the appreciation of the rupee value may be more beneficial as it will act as an enabling factor for increased capital flows and also keeping imported inflation in check. Over the medium-term, bilateral currency swaps and bilateral trade agreements in rupee/rupee internationalisation must be the obvious response for such planning, apart from building up foreign exchange reserves, thereby increasing the import cover. Given that the external sector numbers now look more favourable, now may be the best time to hard sell the strength of the rupee to investors abroad!
With research by Bibeknanda Panda & Saket Hishikar
The author is chief economic advisor, State Bank of India. Views are personal