## Sunday, July 22, 2007

### INR-USD appreciation should be seen in the light of the weak dollar

Abheek Barua has a sensible article in Business Standard where he talks about the long-term forces and immediate exigencies which have given a decline in the US dollar against numerous other currencies, with a continuing gloomy outlook for the USD in the days to come.

As he correctly points out, the recent INR appreciation should be seen in this light. If the USD is losing ground, pegging to the USD and insisting on an unchanging INR/USD rate involves forcing a depreciation in the INR.

The other implication of the weak outlook on the USD is that India must avoid holding USD, in order to avoid losses on the reserves portfolio. These losses are an additional fiscal cost of the present exchange rate regime.

Glancing at the data shows that the trade weighted US dollar (for major currencies) has dropped from 100 to 77.6 between Jan 2003 and Jul 2007. Similar results are found for the broad index. This was, unfortunately, a period where India was holding a lot of USD (though one can't know how much owing to poor transparency at RBI). We could have built a few thousand kilometres of highway using these losses.

#### 5 comments:

1. "We could have built a few thousand kilometres of highway using these losses."

Didn't Ahluwalia propose using reserves for exactly this almost two years. What ever happened to that proposal? Communists didn't like it so our PM didn't move, as usual?

2. I'm not particularly optimistic about "using reserves" in any clever way. Reserves are being purchased in order to manipulate the exchange rate. They are part of the balance sheet of the central bank and ultimately form the monetary base of the country.

Any attempt to sell reserves will affect the exchange rate. An unreconstructed exchange rate policy will merely involve going back to the market on the next day to buy back the reserves. So there is no short cut.

The really useful thing to do is to not hold reserves in the first place, so as to not suffer these losses. This requires rethinking the monetary regime. Once you have the reserves, there is no financial engineering trick to get out of the problem.

3. Pegging to the USD and insisting on an unchanging INR/USD rate involves forcing a depreciation in the INR: As far as dollar is transaction currency internationally, pegging INR/USD is beneficial as it hedges any fores loss.
The other implication of the weak outlook on the USD is that India must avoid holding USD: Who will accept payments in euros/pounds for oil/other goods. See Iran's position that tried to bill oil invoices in euros.

4. An INR/USD fixed/pegged rate is, indeed, convenient for the people who do international transactions. But this crowds out autonomy of monetary policy. The mature market economies of the world do flexible exchange rates + open capital account + autonomous monetary policy.

One importer or one exporter can invoice and transact in whatever currency he pleases. I only said that there are substantial costs when the central bank holds reserves in USD.

5. While I agree with you that holding reserves in USD or USD denominated securities is risky, I believe it could be used to buy assets in other counries that yeild resourcs that india needs - like Oil, coal, iron ore and other metals required for long term growth.

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