The G-20 finance ministers who met over the last weekend at Gyeongju in South Korea came up with a broad agreement that countries must move towards a more market determined exchange rate that reflects the underlying fundamentals of the respective economies. There was also a broad consensus to avoid competitive devaluation that could jeopardise a more uniform global recovery. Predictably, the final communiqu? could not extract any commitment from countries with big current account surpluses that they would appreciate their currencies in the near term. In this respect, it was interesting to note the manner in which Germany and China came together to publicly criticise the US?s policy of following an excessively loose money policy, thereby causing the prospect of multiple asset bubbles in the rest of the world. Germany has got a current account surplus at 5.2% of GDP in the last 12 months and this is higher than 4.9% of GDP, which China has accumulated in the same period. So Germany has become China?s natural ally in opposing a proposal brought by the US to impose a generalised cap on current account surpluses that nations can accumulate.
Although the US move was aimed specifically at China, which is seen as having the most undervalued currency, there are many other countries generating healthy trade surpluses who will not take kindly to the US proposal to have a cap on current account balances. For instance, in the last 12 months,
Singapore has accumulated a current account surplus of 18% of GDP, Norway (14%), Switzerland (10%), Sweden (6%), Japan (3.3%), South Korea (3.2%), Taiwan (9.3%) Saudi Arabia (12%), the Netherlands (6.1%). Though many of these countries are outside the G-20, what is clear is they are all competitive sellers of goods and services in the global market and not necessarily so because of undervalued currencies. So it will be very difficult to impose a generalised cap on current account surpluses that nations accumulate.
Japan historically had surpluses because it has always been very competitive in whatever it exported to America and other parts of the world. Though the US has demanded that nations with excess surpluses appreciate their currencies, Japan is no position to do so because its currency has already touched a 15-year high. From this point onwards, it will be impossible for Japan to further strengthen its currency. If anything, there is a case for the Japanese currency to actually weaken, purely based on fundamentals.
So overall, it is safe to conclude that currencies have not been the fundamental cause of the global economic crises, nor will currency adjustment alone provide a solution to the current global economic imbalance. Therefore, the G-20 finance ministers were right in talking about the need for an overarching macro-prudential framework governing fiscal consolidation, monetary policy, financial sector reform and an appropriate exchange rate policy that would help a more orderly recovery of the world economy.
The problem, however, is nations must first agree to an overarching global macro-prudential framework. Some G-20 nations, including Germany, are therefore right in seeking responsible behaviour from countries that hold reserve currencies. The US and Japan, the two largest economies, have dropped interest rates to near zero in a bid to revive growth. This is now forcing many emerging markets to contemplate imposing capital controls.
RBI has also made it clear that it will intervene if capital inflows became too lumpy in the near future. This is a no brainer. If you can?t absorb the excess dollars, what can you do except prevent them from entering your monetary system. However, India?s worries are rather unique at this stage. It needs enough capital inflows to meet the rapidly widening current account deficit (CAD), which is expected to cross 4% of GDP this fiscal. Policymakers are still wondering whether India?s CAD, which used to be under 2% of GDP in recent years, has structurally moved to a higher plateau of 4%-plus. If this is so, then India will necessarily need a net capital inflow of about $75 billion annually so that after fully covering its CAD it could add some $25 billion to its forex reserves as a safety net.
However, in these highly volatile times, can one say with complete certainty that India will get $75 to $80 billion of net capital inflows every year in a smooth and orderly fashion? Though India continues to be a darling of global investors, recent experience suggests we cannot take for granted orderly net capital inflows of such magnitudes, especially against the backdrop of the global environment in which a double-dip recession is psychologically never ruled out. Recent history tells us that net capital inflows can swing from $105 billion in 2007-08 to less than $20 billion in 2008-09.
RBI is therefore closely watching the quantum and nature of capital inflows coming into India. It must be enough to meet a CAD of 4% of GDP and yet not too much in excess of that. If capital inflows are far in excess of what is needed to meet the CAD, then the central bank will have no choice but to start taking measures to discourage flows at some stage. But signalling this policy stance, especially its timing, can be very tricky for an economy with a widening CAD.
In the event of excess dollar inflows, the political economy will not allow the central bank to let the rupee appreciate beyond what is seen as a fair exchange rate. Many economists reckon the rupee is fairly valued now based on the real effective exchange rate formula applied to a basket of over two dozen countries.
RBI has done well in the past one year to reduce broad money supply growth to less than 15%. This used to be above 20% in the heyday of the global liquidity party leading up to the financial meltdown in 2008. So, RBI has some room to buy up dollars and buttress its forex reserves when capital inflows are consistently good. Remember Dr Venugopal Reddy had done the same by accumulating about $90 billion in additional forex reserves through 2007 and 2008. This came in handy when global liquidity froze in September 2008. India?s forex reserves peaked at $320 billion during the pre-crisis period and are now at less than $285 billion. India will do well to further fortify its reserves when times are good. It will come in handy when the going gets bad. In complex and uncertain times it is better to be creative than ideological.
mk.venu@expressindia.com
