How relevant is our Exchange Rate policy?

by R.M.B Senanayake

The rupee seems to be under downward pressure with demand exceeding market supply. There is some foreign outflow from the bond market as well. The Central Bank is trying to keep it from depreciating. It is resorting to what it describes as ‘moral suasion’. But according to market sources it is more the use of the big stick with the bank monitoring every bid and offer and disallowing what it doesn’t like. There is no objection to the bank supporting the rupee by selling from its own Foreign Reserve. But it wants to build and maintain its Foreign Reserve owing to the heavy foreign debt service commitment. 

Fixed Exchange Rate Policy

The bank has been following a fixed exchange rate policy since the last devaluation was done at the instance of the Treasury in 2012. Very recently it has widened the band between the buying and selling rate within which the rupee is allowed to fluctuate. But it seems to prefer holding it more or less fixed at Rs 130. So it doesn’t seem to allow free trading even within the band. The IMF originally decided to maintain fixed exchange rates owing to the pre-war experience of competitive devaluations by the big powers which harmed international trade. Members were required to hold the par value of their currencies and they were allowed to change them only in case of fundamental macro-economic disequilibrium manifested in their external trade account.

But after the oil price hike of 1972, the USA went off the gold parity and refused to convert the dollar for gold. Instead it allowed the dollar to float in the market. We too have floated the rupee in the 1970s and in 1977 carried out a large depreciation. The two extreme positions for the exchange rate are a fixed rate and a freely floating rate determined by market forces.  But traders in the export-import business prefer a fixed rate rather than a freely floating rate. So the case for a fixed rate is to promote foreign trade and foreign investment. But if the macro-economic fundamentals change and the exchange rate becomes over-valued in terms of its purchasing power parity relative to other countries, then our exports will become uncompetitive and imports too cheap. 

Since 1977 the Central Bank has floated the rupee although guided by an undisclosed par value based on a basket of internationally traded currencies. But the present regime has been averse to allowing the rupee to float and instead preferred to hold it more or less constant as a hedge against inflation. It also helps the Treasury in its foreign debt repayment for otherwise the rupee value of the debt repayment gets to be too large. So the fixed exchange rate policy is largely for the benefit of the Treasury. But it helps to attract foreign capital inflows by removing the risk of exchange depreciation. . 

Floating Rates

There are different versions of floating rates. One favored in the literature is the ‘crawling peg’. But it raises several issues such as how often the peg should be adjusted and how much should it crawl by. Should it be adjusted on the basis of the rates that actually prevailed in the last say one month or three weeks? Also how much should the rate vary? The use of a pre-determined formula could also encourage speculators.

We have large debt servicing payments every year mostly arising from government borrowings in foreign currency. The aggregate of such payments exceed the entire tax revenue. The rupee equivalent of the foreign debt servicing charge will vary with the rate of exchange. If the rupee is allowed to depreciate the rupee value of the foreign debt service burden will keep on increasing, so the Treasury prefers a fixed rate of exchange. Similarly the foreign investors in the local bond and stock markets would like if there is no exchange rate risk for otherwise what they gain by way of higher returns may be lost by the depreciation in the exchange rate. But if the macro-economic fundamentals deteriorate while the exchange rate is held unchanged, then the exports will become uncompetitive while imports will become unduly cheap. This will give a boost to imports while undermining exports as well as the production of import substitutes in the domestic economy. Our exports as a percentage of the GDP have declined from 30% to about 20% presently.

A well known development strategy is the export expansion strategy. This is particularly necessary for a country which does not produce any capital goods and has to import them, for which the country needs a surplus of exports over imports. So we have a large trade deficit promoted particularly by holding the exchange rate over-valued. Although the trade deficit has been coming down it is still too large and requires foreign capital inflows to sustain.

Correcting the Trade Deficit

The trade deficit is not a problem of trade as such, but a result of macro-economic imbalance. The macro-economic equation is as follows: CA* (S-I) + (T-G) where CA is the current account balance; S is Savings; I is investment; T is taxation and G is the government expenditure.

Any deficit in the current account of the balance of payments (external account) reflects an excess of Total Expenditure over Total Income in the economy. To correct a current account deficit, total expenditure must be cut or total income must be increased. Improvements in the current account can be brought about only if savings rise relative to investment or if the government budget balance is improved. The trade deficit cannot be reduced by cutting imports or subsidizing exports alone. These measures will only reduce the growth rate for growth requires imports of capital goods and intermediate goods. Since savings cannot be increased in the short run (savings depend more on total income) the only effective corrective action is to reduce the budget deficits in absolute terms and not relative as a ratio to the GDP as often proclaimed by the authorities. The current account deficit is not a trade related problem although an over-valued exchange rate can make it worse since it encourages more imports and discourages exports.

A current account deficit means that total expenditure exceeds total income. The resultant deficit must be financed by running down external assets or by adding to external liabilities. We can run down foreign exchange reserves or borrow from foreign governments or foreign banks or international organizations like the World Bank or the IMF. The third way is through foreign capital inflows in the form of direct foreign investments or portfolio investments to the stock and bond markets.

The corrective policies

The instruments for correcting the current account deficit are fiscal policy, monetary policy, exchange rate policy and commercial policy. Monetary policy to meet the situation requires that the interest rate paid on domestic assets must meet not only equal the yields abroad but also be higher and allow a risk premium. Otherwise when credit markets abroad in the developed countries tighten and interest rates there go up, foreign capital inflows to us will shrink. The standard for interest rate policy is that the return on large investments should equal the interest rates abroad plus the expected depreciation of the exchange rate plus a risk premium to cover the risk of default. Any large departure from this required level of interest rates will lead to capital outflows and lead to reserve losses or exchange rate problems. I understand that the black market dollar is about Rs 135. The exchange rate policy should take into account this external dimension in the light of our dire need for foreign capital inflows. This is why economists argue for Direct Foreign Investments for there is less risk of capital outflows for the proceeds are invested in land and machinery and equipment. We can’t attract much DFI owing to the bureaucratic and illiberal domestic business environment. We should at least allow a liberal environment in Special Economic Zones as China does.

We also need to prevent the rupee becoming over-valued in terms of its purchasing power parity vis a vis other foreign currencies. Local manufacturers have pointed out that the entry of cheaper goods from India and China has undermined their business prospects. The Chairman of Alufab which assembles and manufactures aluminum fabrications has complained about cheap imports as did the Lanka Confectionery Manufacturers. The Free Trade Pact with China may hasten the end of several import substituting domestic manufactures. A country with an over-valued exchange rate cannot have the luxury of free trade treaties without first correcting the exchange rate for any over-valuation. We did a similar mistake in 1977 when we opened the economy with an inadequate depreciation of the rupee.

We can ignore the current account deficit as long as we can attract sufficient foreign capital inflows to cover the deficit. But our vulnerability increases. The strengthening of the U.S dollar by 6% recently means that capital may flow back to USA unless our interest rates provide a sufficiently higher return compared to US returns. It is only a matter of time before the FED raises interest rates in the USA. 
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