Foreign capital is again surging into Indian markets, exciting opinion as to its drivers. One set regards it a ?hope? rally, founded in optimism about a new, stable government in mid-May; others ascribe it to stabilising policy actions that improved fundamentals, making India far more attractive relative to peers. Whatever be the reason, the point for policy attention is that a $5.2 billion of inflow last month lifted the rupee 3.1% over its end-February value. Considering the rupee traded in the R61-62 range in the five months to March, this is a sharp appreciation in a short time. Several questions arise. Inter alia, why did the Reserve Bank of India (RBI) allow such appreciation? What does this signify from an exchange rate policy perspective? Should not RBI clarify sooner than later to ward off build-up of expectations in several quarters? Is there a danger of repeating past policy errors in managing capital inflows?
Reserves rose by some $4 billion in March. But according to RBI, this was because inflows were augmented by repayments by oil companies in lieu of their past obligations to the central bank. Coupled with that, a mere $5 billion of capital inflow tossed up the rupee by 3%, the movement suggests RBI purchased little foreign currency.
That?s surprising, if only looking at the $32 billion build-up in the central bank?s forward book. Why exactly did RBI allow the currency to drift up so fast and against fundamental considerations? Markets largely consider the rupee fairly valued at R60-61 to the dollar, the same as assessed by the finance ministry not so long ago, while the most recent estimation by the IMF?based on data available as of November 2013, using three different methods?evaluated the ??exchange rate?slightly above levels that can be explained by underlying fundamentals (trading range vis-?-vis the dollar was R62-63 then).
A month is too short a time to gauge policy direction, especially when it is March in India. Maybe the short-term context of market liquidity militated against intervention: the government added R160 billion to the market by its bond buybacks in lieu of cash surplus. Given the peculiar situation, RBI could have been wary to purchase foreign currency and add to this surfeit as overnight interest rates would have collapsed?at 7.05-7.5% in the last week, these were weak enough. It may have worried about easier policy signals, an inconsistency with its monetary stance and damaging its anti-inflationary credentials: any forex purchases would have to be sterilised via open market operations (with consequences for bond yields). Not a happy choice. Or RBI might not have wanted to create perceptions of a one-way bet; but the direction given by the forward premium relative to February counters this.
If RBI was driven by purely short-term liquidity considerations, this leaves open future intervention and its management of sharp appreciation episodes on the strength of short-term capital flows. Assume that the current surge of capital inflow sustains over the next couple of months; not entirely inconceivable if indeed this is a rally of ?hope?. What RBI does now?once the surplus liquidity is out of the system, fresh government borrowings resume and normalcy returns with the new fiscal year?is critical. The central bank?s actions can potentially influence policies, variables and expectations in a dangerous replay of past policy errors in capital flows management. Consider each of the apprehensions and risks.
l An appreciation, which amounts to tightening of monetary conditions, assists the central bank in its fight against inflation. It reduces the burden on the interest rate tool, which RBI might be loathe to further lean upon given the impact on growth. About 30% of the CPI is sensitive to the rupee, with quick transmission into its core component. An appreciation can help accelerate disinflationary impulse by lowering imported input prices. RBI precisely used exchange rate as a stabilisation tool back in 2010 to check inflation, and kept domestic interest rates substantially low. The consequences, in terms of encouraging import demand and widening current account deficit (CAD), are there for us to see.
l There is a dangerous build-up of currency appreciation expectations in the market, where estimates of R56-58 to the dollar in the next few months have started to appear. Since the forward premium is rising, an eventual reversal in foreign capital will result in a sharp correction, increasing volatility. We?ve seen this movie before.
l Expectations can build up on the part of government too. Given the lack of fiscal space, the pressure to find headroom for productive, capital expenditures to revive infrastructure investment and growth are likely to intensify. A stronger rupee is an effective quick-fix; it lowers the subsidy bill on fuel and fertiliser imports. All this has happened before, and there is no guarantee it cannot happen again.
l There is a threat to exports, negatively affected with higher price uncertainty, hedging costs and competitiveness erosion from currency swings driven by flighty foreign capital in recent years. A repetition can further harm exports at a juncture when global demand is unlikely to return to its extraordinary pre-crisis trend and when these are the only visible drivers of GDP growth. Besides, allowing the currency to drift away from fundamentals directly militates against the avowed desire of policymakers to return the current account onto a sustainable, firm footing. This is hardly possible without a lasting, structural correction in the trade balance. While balance of payments have improved in flow terms, the stock position?this weighs more with investors when appraising external vulnerability?is worse from recently-incurred liabilities.
There is an uncertainty surrounding approach to exchange rate management too: the Patel committee has articulated a change in stance by recommending forex reserves? build-up. While issues like reserves? target, etc, are left unstated, it does favour a different sterilisation method to offset monetary impact of forex purchases, rejecting existing tools like open market operations and market stabilisation bonds. Is it the case then that RBI is preparing to implement this element of the Patel committee framework? Or that it isn?t ready yet, pending discussions and approvals with the government in this regard?
Given the recent history of managing capital flows and exchange rate policy, RBI?s actions will be closely watched. If past mistakes are not to be repeated, it is best to discourage unrealistic expectations at the outset.
Renu Kohli
The author is a New Delhi-based macroeconomist
