In the hubbub of news of various central banks trying to prevent a sharp appreciation of their respective currencies, portents of deeper changes in the configuration of global currency markets have remained muted.
In the near term, there is a race to the bottom to exploit the sole remaining engine of global growth?exports. The Swiss National Bank put out an unusually aggressive statement of a resolve to save the Swiss franc from becoming unnaturally attractive. Brazil had earlier tried, maybe even successfully, to spare the real from the same fate. Japan, among the developed countries, has long been one of the leading proponents of weak currency. There is talk of gold prices going up to $2,000/oz by the year end. Indian markets, naturally, are feeling the effects of the increased currency volatility, which stems from the increasing degradation of the status of the dollar as the predominant global reserve currency and the lack of viable alternatives at present.
But the effects of these actions are likely to be transient and shallower in comparison to a deeper realignment of global reserve currencies. There are increasing efforts to internationalise the Chinese currency, the renminbi (RMB), as a precursor to its mantle of a global reserve currency. The government has gradually strengthened the currency (in effect, the RMB has been pegged to the dollar). China?s efforts at internationalisation are also unique in that it is encouraging offshore RMB acceptance rather than onshore, given the existing capital controls. What bigger local vote of confidence for this initiative than reports of Indian corporates looking to tap into China?s liquidity pool (in RMB) to fund India?s investment needs, which makes sense given the shortage of dollar funds in the current environment?
This is both an imperative and an opportunity for India to get in on the game. By 2020, India is expected to become the fourth or fifth largest economy of the world and its currency must reflect this status. Although not immediately a concern, India?s underlying growth dynamics will certainly attract foreign capital. Managing this flow will be a big challenge.
Two issues emerge from these developments. One, what should the Reserve Bank of India?s near-term reaction be? Two, what policies must India?s policy authorities follow to enable the rupee as a global currency over the next decade?
The RBI has provided a textbook response; it has emphasised repeatedly that it will not target a currency level and will only intervene to curb excessive volatility. This is an entirely correct stance, and one which will have many collateral benefits. Popular sentiment is that the rupee strengthening is adverse for exports, and probably so for domestic producers as well, due to a degree of substitution away from domestic producers to cheaper imports. While this is true, the benefits of a stronger rupee in reducing the value of real debt, moderating price pressures and increasing India?s investment attractiveness probably outweigh the adverse impacts. In addition, the comparative appreciation may not be much, given that many of its peer currencies would also be appreciating.
But what must India do to develop the rupee as a global currency? This will require more sustained and well-thought-policies. RBI has been reluctant about full capital convertibility (whose case has actually considerably weakened over the last few years and evidence of ill effects of high external indebtedness is more stark). It is rightly concerned about the loss of efficacy in conducting domestic monetary policy due to the effects of the impossible trinity of open economy macroeconomics (managing the currency, interest rates and liquidity simultaneously when capital is freely mobile), but it is probably inevitable that India will need to open up its capital account over the next few years.
On the currency markets side, two things need to happen. First, it must accelerate its efforts (already initiated through liberalised norms for external commercial borrowings, refinancing domestic loans, broadening the class of potential investors in Indian securities, etc) to increase access of Indian financial entities and corporates to global capital. Despite concerns about India?s fiscal deficit, there is likely to be significant appetite for India?s sovereign bond issues. Second, currency markets in India will need to deepen to manage the consequent volatility and risk, to lower the costs of hedging currency volatility. Onshore currency futures markets have deepened well, true, but are still a fraction of global currency trades; transactions costs remain high. The volumes of rupee trades in offshore non-deliverable forward markets have increased over the past couple of years.
More importantly, India?s absorption capacity of foreign flows needs to increase. Proper structuring of investment products to effectively allocate risks to specific classes of foreign investors will increase confidence and attract foreign capital to investment projects. The ability to service this debt will determine India?s credit quality. This involves sustained cash flows by improving the investment climate, reducing the operating risks and facilitating commissioning schedules.
We have learnt that if we cede market dominance?in any area, not just currencies?control and transaction costs will be dictated by the market leader. For the rupee, this is a game we cannot afford to lose.
The author is senior vice-president, business & economic research, Axis Bank. These are his personal views