A well-managed external sector

Updated: Jan 9 2002, 05:30am hrs
In a turbulent global economy India stands out as an island of stability. The successful management of Indias external sector is not attributed to its relatively closed capital account. The 1990-91 external sector crisis occurred even though we had tightly controlled current and capital accounts. The credit for Indias protection from the recent international turbulence does not go to capital controls but good economic management in areas which impinge on the external sector. Indias foreign exchange reserves as of December 21, 2001 amounted to $48 billion which were higher by $8.2 billion on a year-on-year basis. The net foreign exchange assets to currency ratio (NFA-C ratio) as of December 21, 2001 was at an unprecedented high of 95.2 per cent.

The 5-country model real effective exchange rate, with 1993-94 as base, showed a slight appreciation of 1.1 per cent as of November 15, 2001 but with 1999-2000 as base, the appreciation was 4.6 per cent. With the depreciation of the rupee vis-a-vis the US dollar, between November 15, 2001 and January 2, 2002, the REER appreciation would, in all probability, have been corrected on the 5-country model with 1993-94 as base, but would still reflect an appreciation of about 3.5 per cent over the 1999-2000 base. Vis-a-vis the 36-country model which has lagged information, over the 1993-94 base, as of September 2001, the appreciation was of the order of 8 per cent. Thus, with the 5-country model, with 1999-2000 as base, and the 36 country model, with 1993-94 as base, the rupee could do with some depreciation.

Media hype on the rupee being at an all time low is irrelevant as the depreciation on a year-on-year basis as of December 21, 2001 vis-a-vis the dollar was 2.4 per cent and between December 21, 2001 and January 2, 2002 further depreciation was 0.9 per cent. If the forwards are any guide, the rupee vis-a-vis the dollar could be expected to depreciate by around 6 per cent over a 12 month period. The rupee is tracking the fundamentals fairly well and market participants ought to have no anxieties about it. In fact, the surprise should not be that the rupee is depreciating but why it is not depreciating by a larger amount.

An NFA-C ratio of 95.2 per cent reflects great comfort. An outflow from the reserves, without creation of fresh currency, would result in an equivalent shrinkage in currency. As currency shrinks there would be automatic stabilisers in terms of tight monetary conditions which will bring forth a correction. Advocacy of a high NFA-C ratio should not be identified with the much maligned currency board. In the recent period, the crisis in Argentina has been erroneously identified with the evils of the currency board rather than profligacy and excessive borrowing, to compensate for fiscal mismanagement. What is advocated in the Indian context is that the NFA-C ratio should be kept high. The Reserve Bank of India does not pay attention to the NFA-C ratio, yet it is interesting to note that it has been following this virtuous path without any conscious attempt to do so rather like worshipping a deity without knowing it!

There is a viewpoint being articulated that we are unnecessarily piling up foreign exchange reserves in a mercantilist spirit. The volatile elements of the inflows viz repatriable non-resident deposits, non-resident bonds, portfolio investment, and one years debt servicing total $62.9 billion or 131 per cent of reserves. These reserves cannot be deemed to be excessive. Observers of the Indian exchange rate policy and operations are alarmed each time the rupee depreciates by a few paise vis-a-vis the US dollar. In this context, the RBIs tactical move of also announcing the daily reference rate vis-a-vis the euro is indeed deft. The Indian exchange rate policy operations are nonpareil though its articulation is not as good as its operations.

When the market has a sense of complacency as the rupee-dollar rate moves in a narrow groove and the authorities feel the need for a downward nudge of the exchange rate, they go on a buying spree and the market obliges by a jerky depreciation and the authorities do a quick exit from the market. Now what should be the ideal ground rules for the RBIs intervention operations The RBI should buy spot or undertake spot-forward swaps to alter the inter-temporal perceptions or buy outright forward but it should refrain from large and persistent spot sales. Again, the net forward sales, at any point of time, should be very small. If we look at the RBIs operations this is what it does but does not quite articulate its policy that way. The cliche that the exchange rate is market determined is fine but it does not match the operations.

In a world of exchange rate turbulence, how is it that the Indian exchange rate is generally not buffeted The secret lies in a monetary-fiscal policy mix which, in the ultimate analysis, yields a relatively low inflation over the medium term. Let us not believe that we can have a high medium term inflation and exchange rate stability.

There is a need for an open debate in emerging markets on exchange rate policies. A path-breaking presentation was made by Stephen Grenville, Deputy Governor, Reserve Bank of Australia on Exchange Rate Regimes for Emerging Markets (BIS Review No 97; November 3, 2000) which should send loud echoes in the monetary towers: Allowing a fair degree of volatility around a real exchange rate which is stable over time provides the opportunity for the authorities to have the best of flexibility while leaving open the possibility of intervention (both via interest rates and directly in foreign exchange markets) when the rate has already moved quite some distance away from fundamentals. There are obvious difficult practical issues regarding the operation of intervention, but the intuitive idea is straight-forward enough the further the actual exchange rate has departed from the equilibrium, the more damage the misalignment will do; the more confident the authorities can be that they will be acting as profitable stabilising speculators (buying cheap and selling expensive) and the greater the likelihood of success of any intervention on the part of the authorities. Articulation of the parameters for intervention by the Committee on Capital Account Convertiblity (May 1997), in retrospect, does not appear all that sinful!