It’s not at all clear how national welfare is enhanced by fixing the exchange rate

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New Delhi | Published: September 25, 2018 1:04:26 AM

A dilemma is a situation where a difficult choice must be made between two (or more) alternatives.

The headlines focus on the rapid decline of the rupee

A dilemma is a situation where a difficult choice must be made between two (or more) alternatives. Economists coined the term “trilemma” to describe a specific difficulty in choosing macroeconomic policies. In a nutshell, the idea is that a fixed exchange rate, an open capital account, and an independent monetary policy (three objectives—hence the “tri”) are not simultaneously achievable. The current macroeconomic challenges India faces remind one of this impossibility result.

The headlines focus on the rapid decline of the rupee, and there have been calls for monetary policy responses, as well as interventions to affect the capital account, to halt, reduce, or slow down the decline.

The flip side of the capital account is the current account, where India’s deficit is widening, and also causing concern. What should India’s policymakers do?

Before answering this question, let us step back and note some other aspects of the situation. India retains a complex set of capital controls, and by some measures, it has very limited capital mobility. If that is the case, then the trilemma is not operative, and policymakers can manage the exchange rate while also running a monetary policy suited to domestic inflation conditions. But work I have done in the past with colleague Michael Hutchison, and former students Gurnain Pasricha and Rajeswari Sengupta, indicate that India’s capital controls are leaky, and the capital account is more open than the laws and rules would suggest. Some of the evidence came from measuring actual capital flows, but also from studying the behaviour of offshore markets for forward contracts in the rupee. So, the constraints on policy are real.

More fundamentally, it is not at all clear how national welfare is enhanced by fixing the exchange rate, or by trying to prop it up at a particular level. Indeed, before the current drop, some economists had been arguing that the rupee was overvalued. It is difficult to determine the precise “long-run” equilibrium value of a currency, but if anything, there seems to be a credible argument that rapid growth in East Asia, including China most recently, was aided by undervalued currencies. In that case, the fall in the rupee may be a good thing—helping exporters, reducing imports, and possibly giving India a chance to build some capabilities in manufacturing and in tradeable services.

What about the current account deficit? Like the exchange rate, this is a symptom rather than a cause. A higher dollar price of oil, and demand that is not very responsive to price changes, have increased the import bill, helping to widen the current account deficit and the putting pressure on the rupee. As long as foreign investors were putting money into India, seeking higher returns than elsewhere, the exchange rate was supported. But changes in US monetary and fiscal policy, along with nervousness about other emerging markets, have altered that equilibrium, and the rupee has fallen, somewhat quickly, but also belatedly. The evidence suggests that offshore currency markets, where traders can arbitrage across discrepancies in equilibrium in different locations, are temporarily increasing the downward pressure on the rupee.

The bottom line is that policy makers should not worry too much about the exchange rate. Maybe some intervention is called for if trading is disorderly or market movements become extreme, but even there, any efforts can be a losing battle in the face of global events and large amounts of capital moving around the globe. India has a reasonably well-functioning monetary policy, which has been focusing on keeping domestic inflation down. Blips in inflation because of rupee depreciation will remain blips if monetary policy stays focused. Trying to use interest rates to affect the exchange rate will just muddy the waters.

Trying to control capital flows is also a tricky proposition. This is not to argue for complete capital account openness, on which point economists have varying opinions. But India has plenty of room to rationalize its capital controls, and make both foreign portfolio investment and foreign direct investment smoother and ultimately more attractive. Getting long run policies right is much better than desperate measures such as offering special terms to NRI investors in times of perceived crisis.

In truth, India today is a more robust economy than in the past. It can handle currency fluctuations and capital flows better than in the past, and its policies should be focused on long run growth, not overreacting to what seem to be relatively minor macroeconomic disturbances. Of course, it is possible that global conditions will worsen, as Trump’s trade wars intensify, and some emerging markets such as Turkey become unstable. But if India can manage its fiscal deficit and inflation rate as well as it has been doing, and focus on cleaning up its financial sector problems to make new investment more attractive, the fall in the rupee will be irrelevant, as will the trilemma.

The author is Professor of economics, University of California, Santa Cruz.

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