The attack on the market for the rupee is a mistake

Economic Times, 11 July 2013

Nifty and the rupee are the two most important numbers telling us how India is faring. We may not like the message, but we should not attack the messenger. At a time like this, what India needs most is risk-taking speculative capital: blocking this capital is not in our interests. We are a mostly-open middle income economy with a floating exchange rate -- but our policy making capacity is still designed for the old India.

The two numbers that show how India is faring, that are visible in real time, are Nifty and the rupee. As with all financial market measures, they look forward: they report on the expectations among market participants about the future. In both cases, the price is made by a large and liquid market that has both onshore and offshore components. In both cases, roughly half of the activity is overseas. At the same time, the onshore and the offshore markets are tightly linked by arbitrage.

To help fix intuition, consider trading in shares of ITC at NSE and BSE. While both venues are distinct, the two prices are tightly interconnected. We would do wrong to think of the BSE price for ITC as being distinct from the NSE price for ITC. Arbitrage binds both markets together, and de facto there is one unified pool of liquidity which is resulting in one price.

The same is the case with the rupee. There is an onshore and an offshore market, each of which have exchange-traded and OTC parts. All four components are connected by arbitrage. All four elements work together to result in the price. There is nothing wrong in this arrangement.

The market is a messenger: it aggregates the views of all market participants and reports one number, the price. It is like an opinion poll, except that people are putting their money where their mouth is. Both the Nifty and the rupee are vast markets with innumerable participants. It is very hard to do market manipulation of these markets. As an example, RBI fitfully tries to put large orders on the currency market, in an attempt at doing market manipulation, and fails to make any difference. If a trader as large as the RBI lacks market power, nobody has market power.

In recent days, we in India are seeing an array of authoritarian responses. SEBI and RBI have clamped down on market activity on the onshore exchange-traded currency derivatives. There are newspaper reports that RBI is interfering with the freedom of speech of employees of banks, trying to persuade participants to not take positions on the rupee, and trying to interfere with onshore/offshore arbitrage.

These dirigiste responses are wrong for four reasons. First, if we believe that the market's price is not sound, the solution lies in more liquidity, more speculation and more arbitrage. The actions the government is taking are reducing market efficiency; they are worsening the informativeness of the market's price. A less liquid market will be more volatile and have bigger mispricings.

Second, even if it was thought wise to clamp down on rupee trading, all that the Indian authorities can achieve is to shift activity offshore. Onshore persons who want to bet on the rupee will find ways to do this abroad.

The third issue concerns the respect that policy makers command. India is a middle income economy, with a GDP of $2 trillion, with a mostly open capital account, and a floating exchange rate. We require a commensurate capability in macroeconomic and financial policy. The recent actions are advertising a bankruptcy of ideas. In panic, the people in charge have fallen back to rusty socialist tools. Each of these moves reduces confidence in India. Everyone watching the show is wondering whether the people in charge have the knowledge required to do macroeconomic and financial policy in today's India. This is particularly disappointing as it was believed that after Mr. Chidambaram's return to MoF, the quality of decision making would improve.

The fourth issue concerns funding the Indian CAD and stabilising the rupee. Buying the rupee today is a risky proposition. Who will stabilise the rupee today, by taking a long position on a rupee futures? Only people with a real appetite for risk will take long positions in the rupee today. To stabilise the rupee, we need more speculators, not less. By reducing speculation, we are inducing overshooting. The rupee will have to drop by more before it finds its floor, in a market with fewer speculators.

Badly structured laws and institutions, and low staff quality, was fine when India was a mostly-closed mostly-socialist LDC. The game has changed. Across the world, emerging markets have learned about the importance of building State capacity for doing economic policy. We need to do likewise.

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