By and large, I have felt that RBI has done a pretty good job of the exchange rate. They doubled currency flexibility twice, in 2004 and 2007. In 2009, they shifted to a floating rate. There were two problems:
- They continue to sometimes do tiny blocks of trading on the currency market. In a market of $70 billion a day, a small scale of trading (e.g. $1 billion a month) is irrelevant, so why bother doing it? This has been pointless, but it has done no damage.
- They have failed to correctly communicate to the market that the exchange rate is now a float. I cannot recall an RBI governor who used the phase "floating exchange rate". Many economic agents seem to have got the following message: You're on your own for small fluctuations, but if there are big movements, RBI will block them. This was mis-communication. The people who hedged against small movements but not against large ones, as a consequence of RBI, have now got burned. This is going to further increase the cost of RBI to gain credibility in the years to come, to come to a point where its words are respected.
Barring these two issues, I have felt that RBI has done a pretty good job of the exchange rate. Until now.
RBI has just announced a batch of capital controls against the currency market. This is a mistake:
- When there is turbulence on the currency market, you want greater activity on the currency derivatives market - which is where people protect themselves from currency risk - not less. Recall how the Greek default really damaged the Italians because on that day, the owner of an Italian government bond was told that maybe his CDS would malfunction if an Italian default came about. It was not good for Italy for economic agents to have a reduced ability to manage this risk.
- This will merely shift business to alternative venues - the offshore market and the onshore currency futures market. To the extent that shifting to these venues is tedious or infeasible (e.g. FIIs are banned from the onshore currency futures market and don't have that choice), economic agents will be averse to holding India risk. This is bad for asset prices in India at a particularly difficult time.
- In a climate of pessimism about economic policy, it is important to send out a message, through action and non-action every day, that RBI (and more generally the Indian economic policy establishment) possesses top quality knowledge and decision-capabilities in economics and finance. This action of RBI reinforces the gloom about economic policy capabilities in India.
In April, Ila Patnaik and I released a paper titled Did the Indian capital controls work as a tool of macroeconomic policy? Our answer was largely in the negative. RBI's actions of today are likely to shape up as yet another episode of this larger theme. It might make things worse for the rupee, for Nifty, etc.; to this extent these decisions would not be irrelevant.
Financial regulation should be focused on the problems of consumer protection, micro-prudential regulation, market integrity and systemic risk. It should not be used as a tool for short-term macroeconomic policy. If this is done, it damages market liquidity and yields a less capable financial market. This further damages the limited monetary policy transmission that RBI possesses.