Righting the rupee

Asian Wall Street Journal, 18 May 2007

India is currently muddling through what could be called a currency "drama" as opposed to a currency "crisis." The rupee has appreciated sharply against the dollar -- 8.29% from March 15 to April 25 this year alone. That's a marked departure from the six-year period between 2000 and 2006 when the volatility of the rupee averaged only 3.2% per year. Exporters are understandably nervous, but so is the Reserve Bank of India. One thing is certain in the midst of all this uncertainty: India needs a new monetary framework.

Why the volatility? In a word, globalization. In 1992, India's nominal GDP was $240 billion. Back then, gross capital flows -- summing across the current account and the capital account -- were $97 billion. Today, both values are in the range of a $1 trillion a year. While GDP has roughly quadrupled in the past 15 years, transactions on the current account and the capital account have increased by roughly 10 times.

The monetary policy that used to work well in the more closed India of the 1990s has run into trouble in recent years. The RBI concerned itself with controlling rupee-dollar volatility, in addition to trying to undervalue the exchange rate to support exports. This required steadily buying U.S. dollars on the currency market. These purchases injected rupees into the local economy, creating inflation. Trying to offset this, the RBI engaged in partial "sterilization" by selling government bonds to pull rupees back under a Market Stabilization Scheme (MSS). The interest paid on these bonds was seen as an acceptable operating cost to stabilize the currency.

But lately this strategy has run into trouble from many directions. First, incomplete sterilization led to rapid growth in money supply and credit, and has ignited inflation. Consumer price inflation accelerated to 7.6% in February 2007 from 2.2% in April 2004. Inflation rates like these have serious political implications, especially in a nation like India where politicians are unusually inflation-conscious. Whenever the Consumer Price Index crosses 4%, the ruling party believes it will lose elections. So it wasn't surprising that by early 2007, the governing United Progressive Alliance (UPA) was fully geared up to wrestle inflation back to below 4% in time for the elections scheduled for 2009.

This meant that currency intervention had to be completely sterilized -- either that or the RBI's currency intervention had to cease. At the same time, the fiscal costs of the central bank's currency policy were becoming increasingly unpleasant. The interest cost of MSS were growing and had become a glaringly large public expenditure. At the same time, the sale of bonds had been driving up interest rates and affecting the government's borrowing costs.

Early in 2007, the inflation problem rose to a crescendo. The central bank's policy of undervaluing the rupee was not helping, for an INR appreciation would actually help reduce the prices of traded goods. The central bank was caught in a bind, pressured to limit MSS issuance to avoid driving up interest rates, pressured to avoid nonsterilized intervention to avoid fueling inflation, and pressured to permit a rupee appreciation to help tame inflation.

Speculators in India and elsewhere understood the situation, and a surge of capital inflows ensued. This was, in effect, the reverse of a traditional speculative attack with speculators pouring money into India in hopes that the rupee would appreciate. In response, the RBI pulled out all the stops and purchased $11.9 billion of foreign currency in February alone -- its biggest one-month purchase ever. To make matters worse, this purchase appears to have been largely unsterilized. In early March, it became clear that this policy framework was unsustainable and unacceptable. In mid-March, the central bank retreated from its foray into the currency markets, resulting in the aforementioned dramatic rupee appreciation.

As is often the case, India's currency woes have brought to light flaws in the country's monetary policy framework. First among these is the RBI's lack of transparency. Everyone knows that the rupee is appreciating, but no one knows what the RBI thinks about it. The precise scope of the bank's intervention up to now is a bit of a mystery, let alone what it might do in the future. So no one knows whether the rupee is currently at a market equilibrium, or whether today's exchange rate is a new line in the sand drawn by RBI that it will act aggressively to defend.

A recent study of central-bank transparency by the U.S.-based National Bureau for Economic Research points out the problem. On a scale of 0 to 15, Asian central banks improved as a whole, scoring 5.1 in 2005, compared to 3 in 1998. China's transparency improved dramatically, to 4.5 from 1. But India's central bank stagnated at a score of 2 from 1998 to 2005. Better RBI transparency is clearly a good place to begin reforms.

And then there are the exporters. Most Indian exporters, lulled into complacency by the low volatility of the RBI's pegged exchange rate, were unprepared for the levels of currency volatility seen in recent months. The onshore currency forward market has many imperfections, and capital controls inhibit the ability of local firms to use the burgeoning rupee-dollar non-deliverable forward (NDF) markets in Hong Kong and Singapore. A currency futures market would be an ideal solution for hedging, allowing the rupee market to stay in India. This market, however, is currently banned by the RBI.

Still, there are several different scenarios that could resolve India's currency conundrum. The RBI could seek a continuation of the macro policy framework devised in the early 1990s. This would require a substantial reversal of India's globalization, after which the RBI would go back to trading on the currency market. In this scenario, substantial capital controls would be brought back. This option is, of course, not feasible politically and economically -- as Thailand's experience has demonstrated. Moreover, the private sector would simply evade capital controls by misinvoicing on the huge current account.

Alternately, Parliament could force reforms by enacting legislation similar to the Bank of England reform of 1997. This would lend the RBI independence, transparency, predictability and accountability. It would also explicitly definethe bank's goals, such as the stabilization of domestic business cycles and the provision of a low and predictable inflation rate.

Lastly, the RBI could reform itself from within without any change to its authorizing legislation. This would be analogous to the evolution of the U.S. monetary policy framework under Paul Volcker and Alan Greenspan, when fundamental changes in the behavior of the Fed were executed without changing the law. A forward-looking team at the RBI has the ability to implement de facto inflation targeting, foster the development of modern financial markets, remove capital controls, and set short-term interest rates through a vote by a respected monetary policy committee with full transparency -- all without changing the RBI Act.

This last scenario is the most desirable. Fortunately, there is more political support for low inflation than there is for subsidizing exporters, so it is likely that India will go down the path of targeting inflation. In the long run however, what the RBI needs is a Volcker-style reform program that focuses monetary policy on bringing inflation to a reliable trot. Exporters will complain, but the Indian economy will be better off for it.

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