India’s stance on exchange rate policy is once again at the centre of a new debate. What is peculiar this time though is the lead taken by the government itself. In a post-Budget interview (The Economic Times, March 2, 2015), the chief economic advisor (CEA), Arvind Subramanian , laid out a tentative framework of a new exchange rate strategy: Sustaining a weaker currency by an aggressive forex reserves’ build-up—$750 billion-$1 trillion in the medium-term—with letting the rupee dip at every opportunity. These statements are radically different from the official RBI position, repeated severally in no uncertain terms, that forex market intervention never targets reserves but only aims to minimise volatility; a build-up, if any, is a residual outcome.
Since the CEA’s remark came just a day after the Budget—an unusual time to talk about exchange rate policy—it escaped the kind of attention it would normally attract. Analysts seemed to have underplayed its significance, presumably attributing it to an academic viewpoint instead of a serious policy option. But a careful analysis of developments since the government’s announcement of the Make-in-India campaign as the fulcrum of its economic strategy to revive manufacturing growth gives a sense that an implicit design of a new exchange rate strategy—in line with China’s successful experience—is being actively considered.
The Make-in-India campaign, regardless of the many explanations extended so far, clearly looks at grabbing a bigger share of the external market by boosting exports. This has been a three-legged strategy so far: open the economy to FDI in restricted sectors; ease doing business; and execute financial sector reforms. The finance minister explained that if costs of doing business go down and efficiency improves, it doesn’t matter if manufacturers make for domestic or export markets.
It is in this light that the CEA’s statements bear tremendous significance. If this three-legged focus upon economic efficiency was a complete package to sustained high growth rate, why was Subramanian making out a case for a weaker currency? Does he harbour doubts and hence feels a fourth leg, i.e., weaker currency, would be needed? Or was he alluding to the fact that given political economy constraints of improving domestic efficiency, a strategy to rope in a fourth leg would be more practical?
It must be underlined here that though he was forthright in saying that rarely an economy had managed to sustain near double-digit growth rates for 2-3 decades without an active, weak-currency strategy, he was equally candid in admitting that working out such an approach was rather complex and he was yet to think it through.
Consider the fundamental difference of this approach from RBI’s current exchange rate strategy: Irrespective of its official position, RBI is generally perceived to intervene in the foreign exchange market not only to stem short-term volatility, but also to actively manage the exchange rate to more or less align to its estimated fundamental value. The resulting reserves’ build-up then entails a budgetary cost.
By contrast, what the CEA is suggesting is a deliberate undervaluation of the currency and build-up of a war chest of forex reserves of a trillion dollar or more to flex muscles. How practical is this proposition?
The Achilles’ heels
At least three attributes of the Indian economy and policy indicate inconsistencies and potential vulnerabilities.
* Costs of intervention: There are substantial costs linked to reserves’ accretion, i.e., the interest burden from exchange of foreign-to-domestic securities. No matter how this takes place—through market stabilisation bond issues or a remunerated standing deposit facility suggested by the Urjit Patel committee—the burden devolves directly upon the fisc in the former case, or indirectly through reduced dividend transfers from the central bank. Either interest expenses rise or revenues get lowered, straining an already stretched fiscal position. China incurred such costs too, but could bear this quasi-fiscal weight for a prolonged period due to robust public balances; plus the costs were not prohibitively high because Chinese inflation and interest rates remained relatively low, quite unlike India.
* Increasingly liberal capital account: India has moved in this direction for over two decades now; currency internationalisation as antidote to offshore rupee-trading centers that drive onshore currency moves is being talked of. The Financial Sector Legislative Reforms Commission (FSLRC), whose proposals are the bedrock of the government’s financial sector reform agenda, recommends redesign of India’s current capital control framework to introduce a legal basis with recourse to review of decisions, amongst other things. How does this reconcile with a situation say, of a prolonged surge in capital flows driving currency appreciation with reserves’ absorption, sterilisation and macroeconomic management hitting the limits in prevention or threatening financial stability? China kept its capital account shut throughout the undervalued exchange rate, export-led growth years; it began relaxing restrictions less than a decade ago when it recalibrated its growth strategy. Can India revert?
* A difficult external environment: This is characterised by low demand and depreciating currencies, notably in Japan and the Eurozone as they seek to export their way out of their recessions. India can join the weak-currency party but may not get much out of the wars in this setting and will incur huge costs. The cost-benefits may not be sustainable.
We must note also that China’s $4 trillion of reserves have been accumulated from current account surpluses, i.e., export receipts and, hence, are their very own. But India’s reserves have been, and are suggested to be built from capital account surpluses, which means incurring liabilities or increased claims of non-residents upon the country. So reserves don’t and wouldn’t really belong to the nation; the country would have to be ready to part with them whenever required. No wonder RBI feels uncomfortable, leading its Governor, Raghuram Rajan to caution: the world is not ready for another China; Make-for-India would be better than Made-in-India. Although the Governor has recently clarified his comments were misunderstood, in the current context of the exchange rate debate, his initial views appear more relevant!
The author is a New Delhi-based economist