And just to illustrate the yo-yo nature, it is worth noting that Turkey has recently got a rating upgrade, owing to its International Monetary Fund-mandated austerity programme, which has brought inflation down from 100 per cent to almost single digits, and enabled it to meet its monetary and fiscal targets.
By contrast, the Indian rupees journey has been reassuringly sedate and unidirectional. The annual depreciation is more predictable, roughly being equal to the inflation differential between India and the US. And the volatility also has been declining. From April 1993 to February 2002, the coefficient of variation in the rupee was 100 per cent. But measured over the last 11 months, it is as low as 40 per cent.
The downward direction, however, has become somewhat puzzling. Shouldnt the rupee be appreciating After two long decades of a negative current account, India may be heading toward a current account surplus (if oil prices allow). Even the capital account has seen sustained inflows for the last 18 months in the form of foreign institutional investor portfolio investments or foreign direct investment. If the rupee were completely market-determined, we should have seen an appreciation. But the Indian rupee is under a managed float, the manager of the flotation being the Reserve Bank of India.
Most of the recent foreign currency inflows have been absorbed by the RBI, which has enabled the rupee to continue its predictable downward path. The RBI added an unprecedented $11 bn, ie almost 25 per cent, to forex reserves during FY 2002. During this time the rupee depreciated by 4.63 per cent against the US dollar, by 3.94 per cent against the euro, and appreciated by 1.65 per cent against the yen. In the last four months alone, forex reserves have gone up by almost $5 bn.
The reason RBI continues to stock up on forex is not just to pay for volatile oil prices or to repay those Resurgent India Bonds and India Millennium Deposits, but more so to keep the rupee steadily depreciating. This helps contain the volatility of the rupee and also helps exports. A weaker rupee has also got the support of an alliance of exporters and domestic manufacturers who feel the threat of cheap imports. In a World Trade Organisation-mandated world, domestic industry has lost the protection of high import tariffs and quantitative restrictions. Similarly, exporters are likely to lose the advantage of export subsidies. For both these categories, a weak rupee is a welcome source of support. But more important than a depreciating rupee is a stable rupee. The stability, or low volatility, is a confidence building measure for importers, exporters and investors, be they FII or FDI.
Volatility management of the currency is an important task of the central bank in an emerging economy like India. A central bank can choose to emphasise one of three targets inflation, currency, and interest rates. Only in the extreme case of a fixed currency peg (as in pre-1997 Thai baht or the present Chinese yuan), will the other two targets become irrelevant. In all other cases, the three variables can be managed simultaneously. But there will be trade-offs. The more the emphasis on the management and control of one variable, the lesser its volatility. But then, the other two variables can go haywire. Thus, an indirect way of deducing the current focus of RBIs policy is to look at which variable exhibits the lowest volatility. If the rupee is exhibiting low volatility, then one can conclude that it must be higher on the RBIs current priority. In that case interest rates and inflation may fluctuate more than expected. Of course, despite RBIs neglect, the other two variables might exhibit low volatility due to other macroeconomic factors.
Sure the rupee has come stable. Is it solely because of reserves management Is there a correlation between monthly rupee fluctuation and forex stock fluctuation It is tempting to assert that the downward movement of the rupee has been positively and significantly correlated with reserve accumulation. The long term statistical correlation, however, is negative and almost insignificant. Reserve accumulation has been going on for quite some time. The relevant question then is, what is the cost of maintaining a low (but non-zero) rupee volatility via reserve management
Clearly, the opportunity cost of maintaining high (and perhaps volatile) reserves includes the cost of not pre-paying foreign debt and foregoing profitable trading and investment opportunities. The benefit includes increased stability, fending off speculators, and improved investment climate. The yuan is rock solid since there is a huge forex mountain behind it. But thats an extreme case. It is nevertheless true that in a managed float such as the rupee, forex reserves offer a powerful tool of cushioning currency volatility. But volatility absorption via reserve management does have an opportunity cost. In that sense, lower volatility has to be purchased at a price! In the current scenario of worldwide uncertainty, low rates and stalled reforms, this price seems justified.
Ajit Ranade is Chief Economist, ABN Amro Bank, India