The mother of all currency defences

Business Standard, 11 January 2016

The currency defence that everyone remembers is that of the Pound in 1992. The UK had a managed exchange rate as part of the `European Montary System' (EMS). The market understood that the exchange rate set by the EMS was wrong, and that a big pound devaluation was required. Capital started flying out of the UK as everyone wanted to avoid the 10% loss from a 10% depreciation. The government tried to raise rates by 500 bps in order to defend the pound. This lasted three days. The UK economy was quite weak, and it made no political sense to hike rates like this. The drama ended with the UK exiting the EMS, and ending the interest rate defence.

This was a clean and logical story. India's currency defence of 2013 is a more messy one. The market understood that a big exchange rate depreciation was required. The government tried to raise rates by 400 bps in order to defend the rupee. Alongside this, there were numerous reversals of reforms which were thought to help the rupee defence. Unlike the UK, this drama lasted for months, as action after action was piled on in trying to fight this battle. The actions did not work: the exchange rate depreciated from 62 to 70. Nifty also lost 15% owing to the unpleasant things that were done in the defence.

Today's drama is in China. The Chinese RMB is not a market determined rate. When the RMB started coming under pressure last year, the authorities decided to stand firm and not allow a depreciation.

At first, this appeared to be quite feasible. China had over $3 trillion of reserves, and a full central planning system controlling finance. But still, lots of things went wrong. It is locals who know the most about problems in the economy, and locals have a lot to gain by moving assets out to avoid a coming depreciation. Substantial capital flight has begun out of China. Even though the country has a collapse in investment and thus a current account surplus, the capital flight is so large that reserves have to be sold to uphold the exchange rate.

For a few months, reserves have declined by a bit less than $100 billion a month. We may think that with $3 trillion of reserves, the authorities can handle this scale of outflow for 30 months. Things might be a bit worse. Questions are being raised about the liquidity of the reserves portfolio. There are only a few global asset classes where the Chinese government can easily dispose of $100 billion of assets per month. A lot of the reserves portfolio might not be in these liquid asset classes. There are no reliable estimates available about the sub-component of the Chinese reserves -- that one may term `core reserves' -- which can be easily sold. Placing a bet on a large RMB depreciation is synonymous with believing that core reserves will not last 30 months.

As significant RMB depreciation becomes imminent, the pressure of capital flight becomes bigger. If a 10% depreciation were coming tomorrow, it's profitable to sell assets, take money out, wait for the depreciation, and come back with a 10% profit. This is generating pressure on local asset prices, as people sell land and equity assets in order to profit from the coming depreciation. Similarly, as significant RMB depreciation becomes imminent, rational speculators from all over the world are placing bets on it, as had happened on the Pound in 1992 and the Rupee in 2013.

The authorities could mount an exchange rate defence as was done in the UK and India by raising interest rates. But the Chinese economy is not in very good shape, so raising rates is not a good choice.

In 1992, it took the UK all of three days to end the misery by floating the exchange rate. Could China do the same? The first point is to recall the atmosphere of India in 2013. Once a dogfight with speculators has begun, it takes a lot of maturity to accept defeat in three days. Career considerations of key actors, rather than economic rationality, will shape the outcome.

The deeper problem is the drug of the managed exchange rate. For decades, companies in China have lived with low exchange rate risk. To produce and export from China is to benefit from this subsidy. Sheltering firms from the market has juvenilised them. It takes years for firms to develop the organisational capability to live in a genuine market economy, where prices fluctuate every day, where investment decisions are risky and require adequate thinking and risk management.

The `China model' tugs at the heartstrings of three kinds of people. The Left enjoys the State domination over citizens and markets found in China. Men of action like to just rush ahead and (say) build highways, and not have to deal with deliberation or complex policy thinking. Businessmen and finance people feel at home with a country which runs like a company, in contrast with the alien processes of political economy and public policy in a democracy.

China's success seemed to show that the standard recipes of rule of law, market economics, and institution building, were not essential. Numerous bad ideas in the Indian economic policy discourse are sold on the grounds that `China does it'.

By 2006, perceptive observers had started understanding that the `China model' had fundamental flaws, that Chinese growth was going to slow down considerably, and that it was particularly difficult for China to get going on the main track of building institutions for a liberal democracy. Heterodox policies work for some time, but they are not a foundation for sustained prosperity, and they do not power a country to the ranks of advanced nations. For us in India, this re-emphasises our main highway of making our liberal democracy work. India's journey is about freedom, the rule of law, institution building and State capacity.

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