Should we have picked this battle?

Economic Times, 7 August 2013

There are many, many things going wrong in Indian economic policy. The rupee was the wrong place to pick a battle. The cost-benefit ratio does not make sense. The damage caused by waging war on the rupee dwarfs the near-zero impact that was obtained. It is better to let the market choose the exchange rate, and focus government upon things that only government can do.

Learning to live with market pricing

The rupee has been a floating exchange rate from March 2007 onwards. In any country, it is a learning process, for everyone to get used to the idea that the government has nothing to do with the exchange rate. For a comparison, look back at Nifty or the price of petrol or diesel. It has taken many years for people to get used to the idea that the government has nothing to do with these market outcomes. Every now and then, when a large move in prices takes place, there are fresh demands that government must do something to interfere with the functioning of the market. We need to stay on course to get everyone used to the idea that no policy maker has any idea about what is the correct price of petrol or the rupee.

Balance sheet effects

There is a lot of loose talk about balance sheet effects associated with rupee depreciation. The government does not borrow in dollars. That leaves corporate exposures. When a company borrows in dollars, this borrowing can be offset by hedging using currency derivatives or using natural hedges. The overall hedging status shows up as the sensitivity of the stock price to the rupee. For a company that is vulnerable to depreciation, on average, when the rupee depreciates, the stock price goes down.

In the Macro/Finance Group at NIPFP, we recently analysed data for the 1282 firms in the CMIE Cospi index [methodology]. There are 81 firms who stand to (statistically) significantly gain from rupee depreciation. There is not even one company which stands to (statistically) significantly lose from rupee depreciation.

Did something unusual happen to the rupee?

In 2013, rupee fluctuations were not odd. There has been a 12% rupee depreciation. Roughly half of this is simply about fluctuations of the dollar, euro and yen. An India-specific component of six percentage points in this year is in line with high inflation in India and weakening conditions in politics and the economy. When compared with other emerging markets, the rupee is roughly in the middle of the pack.

The data does not show `free fall' or `speculative froth'. The rupee has done many such moves before.

Where is the dry powder?

So far, the US Fed has only envisioned circumstances in the future when it will scale back its bond buying program. We might have liked to save up dry powder for events in the future when the US Fed actually starts buying less than $85 billion per month, at which time Indian assets will become less attractive. Instead, we got into a tizzy while nothing was amiss.

Pragmatic cost-benefit analysis

We have reversed financial development, we have messed up the operating procedure of monetary policy, we have created chaos in the short end of the bond market, we have impeded Indian households taking refuge from high inflation by purchasing gold, we have resurrected gold smuggling, we have raised the possibility of reversing trade reforms. In return for what?

There are numerous problems that require the attention of the government. We must build currency derivatives trading, including giving access to foreign investors which would make it possible for them to hedge their investments in India. We must strengthen the monetary policy transmission, and evolve RBI into a modern central bank with clarity of purpose. We must fight inflation, and woo (not force) the Indian household to start trusting the Indian rupee again. We must fight criminality. We must say to the whole world that India is moving forward with economic reforms.

All this requires the scarcest thing in Indian economic policy: the prioritisation and time of policy makers. Instead, the agenda of economic policy was substantially hijacked by a dogfight with currency speculators. Yes, the Indian government can make a difference to the rupee. As recent events have demonstrated, the cost of achieving this is too high and is not worth the trouble. Governors Reddy and Subbarao both wrecked their stint at the RBI by fighting against the floating exchange rate.

Economic policy strategy is about wisely envisioning the outcome of future battles, rather than impetuously plunging into a battle and learning the hard way. We need more high quality analysis, rooted in an understanding of open economy finance and macroeconomics, in picking a few battles that are worth winning, and can be won.

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