Monday, April 28, 2008

What is the undistorted rupee-dollar rate?

Writing in Business Standard today, Abheek Barua notices that the INR appreciation of 2007, in the end, didn't do much to exports growth despite a sharply slowing world economy. The five observations from October 2007 onwards show an average value for year-on-year growth of merchandise exports of 30%, and India always does better on services exports than we do with merchandise exports. This is clearly inconsistent with the doom and gloom about rupee appreciation and exports growth. And, the evidence does suggest that rupee appreciation could help contain this inflationary spiral.

But he wonders whether conditions on the currency market have changed so that a more hands-off approach by the RBI would actually result in appreciation. As he says:

I think the question that needs to be answered carefully at this stage (and that this debate has skirted) is whether the rupee will actually appreciate much if the RBI were to let it move freely. As someone who watches the forex market closely, my sense is that it won't. Capital inflows have dwindled quite palpably and with commodity prices at record highs, the current account deficit is unlikely to narrow. Going forward, I won't be surprised if the rupee depreciates a bit if the central bank allows free play of market forces.

Here's data for reserves accumulation per month in the recent period:

2007-02 14.1
2007-03 4.7
2007-04 4.9
2007-05 3.7
2007-06 5.4
2007-07 13.6
2007-08 1.7
2007-09 18.4
2007-10 16.4
2007-11 8.2
2007-12 1.8
2008-01 17.0
2008-02 7.6
2008-03 7.8

As a thumb-rule, 80% of reserves accumulation is currency trading by RBI. These are all massive numbers; in my reckoning, anything bigger than $1 billion a month leads to unacceptable monetary policy distortions. And, the true size of the market manipulation is bigger than this when one takes into account the purchases on the forward market.

This data runs till March. Suppose there has actually been a palpable change in currency market conditions in April, and that easing up on market manipulation doesn't affect the rupee-dollar exchange rate. What, then, would policy makers do? The first answer is: Reverse the capital controls of 2007 against ECB and against PNs, so as to get back to the status quo ante as of April 2007 on India's capital controls.

The second answer is: Sell reserves. It makes no sense for India to hold so much reserves. We are suffering visible fiscal costs (MSS payments) and invisible fiscal costs (losses on the reserves portfolio) owing to these reserves. Every opportunity should be used to shed reserves and thus reduce these costs.

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