With the new government taking over, all eyes are now focused upon the forthcoming budget for this financial year. Against a backdrop of stagflation and no monetary-fiscal headroom for policy support, suggestions are pouring in about how to create budgetary space to increase capital expenditure and kickstart the investment cycle. But the joyous boom in capital inflows that is pressurising the rupee to appreciate, despite brisk intervention by RBI, will soon be straining the budget too. This is by way of fiscal cost of intervention, which directly or indirectly devolves upon the government balance sheet. The forthcoming budgetary exercise needs to explicitly recognise and provide for such costs, given the heavy inflow of foreign capital, commonly expected to sustain.
Little is known at this point about how much RBI may buy ahead. The extent of intervention depends upon where it sees the rupee, how much deviation and volatility it is willing to tolerate, how much reserves it wishes to build, and above all, the magnitude, persistence and type of foreign capital flowing into the country. While nothing can be predicted, there are pointers towards substantial intervention in the coming months.
Consider capital flows to start with. After net capital inflow of $5.2 billion in March, against which the RBI bought $8.8 billion, inflows have boomed again in May: Month-to-date capital inflow touched $4 billion, with an escalation to almost $600 billion daily in this week as investors? political expectations were met. Brisk intervention by RBI has been reported in this week. Data upto May 9 showed foreign exchange reserves (assets) climbed by $4.5 billion already; possibly, these would have risen more, although reports suggest forward-purchases by the central bank. Still, the rupee has already risen 2.5% in May so far, jumping 1.2% in just the first day of this week, while expectations of rupee-dollar value at 57 (currently at 58.64) have built up. While no one can accurately predict the future capital flows? scenario, the fact of a stable, decisive government has made it favourable. Benchmark price index targets like Sensex are revised up more than 15% and many predict this to be the start of a decade-long bull market. A surge may very well be here to stay.
Against this are policy choices that straddle macroeconomic concerns and broader political economy. Exports are the only growth stimulus at this point, which underlines the need for a stable, competitive currency; a global ?currency-war? environment is an additional pressure to maintain your own currency?s competitiveness. Macrofinancial stability considerations are another pointer; although the external payments position has become positive, vulnerability indicators like reserves relative to GDP and short-term debt, import cover, etc, need strengthening.
From most angles however, it appears RBI may have to significantly intervene to prevent the rupee from rising too much. That points to an emerging budgetary cost. Why?
Forex market intervention to check currency appreciation and build reserves involves purchasing excess foreign currency inflow by the central bank, which injects rupees into the monetary system. The resulting expansion of the monetary base must then be adjusted to keep it consistent with the prevailing monetary policy stance. Excess reserve money is removed by off-setting sterilisation operations. Sterilisation involves the use of one or a combination of monetary tools, viz. repo operations under LAF, open market sales of government bonds (OMOs), special market stabilisation bond sales (MSS), retaining the government?s surplus balances with RBI, forex swaps and an increase in cash reserves requirements of banks (CRR), to withdraw surplus money from the system.
The cost of intervention is simply the differential between the yield on government securities and return on foreign exchange assets. Since the former is typically higher, the interest costs arising from the use of any tool other than CRR, devolves directly upon RBI (LAF, forex swaps) or the government (OMOs, MSS). But because RBI?s surpluses are always transferred as dividend payments to the government at the end of each accounting year (July-June), any reduction in its profits impacts the government?s ?non-tax revenue? receipts. Typically, the budget provides for this, including dividends and profit receipts from other public sector entities. For example, a sum of R569 billion is provided for in the 2014-15 interim budget; in 2013-14, of the total R882 billion of dividends-profits received by the government, more than a third were dividend transfers by RBI (R330 billion). Indirectly too, therefore, the costs of intervention are borne by the government.
In January, the Urjit Patel Committee Report (UPC) recommended the RBI ??build a sterilisation reserve out of its existing and evolving portfolio of GoI securities across the range of maturities, but accentuated towards a ?strike capability? to rapidly intervene at the short end?. It also suggested a shift away from collateral-based sterilisation tools, as those explained above are, towards ??a remunerated standing deposit facility?which will effectively empower it with unlimited sterilisation capability?. This however, requires an amendment in the RBI Act. Until then, the dependence upon traditional sterilisation tools will remain.
Whatever are the central bank?s forecasts for capital inflows in 2014-15, and whatever amount of dollar it intends to buy, the government needs to incorporate the quasi-fiscal costs of intervention into the budget math. Even as it combs the balance sheet to find some headroom for an investment boost, the costs of preserving macroeconomic stability will take away some space, howsoever small it may be.
The author is a New Delhi-based macroeconomist