Themes > Current Issues
30.07.2000
C.P.
Chandrasekhar
Volatility
in India's foreign exchange markets has forced the Reserve Bank of
India (RBI) to change course. In July, the RBI suddenly reversed the
agenda of easing money supply and reducing interest rates that it
had been consistently pursuing for more than two years now. To further
that agenda, the RBI had periodically reduced the Cash Reserve Ratio
(CRR) applicable to the banking system, and the Bank Rate, or the
rate at which the central bank provides credit to the banking system.
The most recent set of such reductions was announced on April 1, 2000.
Four months later, priorities have changed. The Bank Rate which had
been brought down in six instalments from 11 per cent in January 1998
to 7 per cent as recently as April 2000 was, on 21 July, hiked by
one percentage point to 8 per cent. The CRR too was raised by half
a percentage point to 8.5 per cent. The RBI had decided to stabilise
the rupee by choking off credit and rendering it more expensive.
This sudden reversal in policy came as a reaction to an acceleration of the hitherto gradual depreciation in the value of the rupee. The rupee, which traded at 43.66 to the dollar at the beginning of May 2000, fell to 44.58 by the end of that month and stood at 44.7 around the middle of July. , The RBIšs announcement came when this gradual depreciation gathered momentum, leading to a 15 paise intra-day fall in the value of the rupee relative to the dollar, which took it below the psychological milestone of Rs. 45 to the dollar. The RBIšs Bank Rate and CRR hike came as a swift reaction aimed halting this accelerated depreciation.
There are three ways in which a squeeze in liquidity and a hike in interest rates can affect the dollaršs value in a relatively free foreign exchange market. To start with, in the medium term, it could do so by affecting the level of economic activity. The higher cost of and reduced access to finance would, by curtailing debt incurred to sustain current operations and undertake investment, dampen economic activity and reduce import demand. The consequent improvement in the trade and current account balances, if any, can strengthen the rupee. Secondly, by setting a higher floor to interest rates, the hike in the Bank Rate could increase returns earned by financial investors, thereby attracting financial inflows from abroad. The consequent increase in dollar supply in domestic foreign exchange markets could prop up the rupee. Finally, by making access to rupee resources more difficult and more expensive it can discourage speculators from borrowing rupee funds to speculate on the dollar. To the extent that speculation is responsible for the depreciation of the rupee, this would serve to strengthen the currency.
The intent of the RBIšs manoeuvre is thus clear. What is puzzling, however, is the reason why the observed decline in the value of the rupee, which should be considered Œnormalš in the world of "market-determined" exchange rates that financial liberalisation has put in place, should have invited such a knee-jerk reaction. In fact, there are many who believe that there is a strong case for rupee depreciation. To start with, the dollar has in the recent past appreciated substantially against the currencies of other developed countries, and if the rupee remains stable vis-ā-vis the dollar, Indiašs competitiveness in developed country markets (other than the US) would be affected adversely. Further, even though exchange rates in East Asia have risen from the troughs they reached during the financial crisis of 1997-98, they are still well below their pre-crisis levels. This has given exporters from these countries, which are Indiašs competitors in world markets, an advantage. For these and other reasons, rupee depreciation appeared warranted, especially since trade liberalisation had rendered the use of subsidies as a measure of promoting exports difficult.
In practice, however, an unusual combination of circumstances had ensured that the rupee was under pressure to appreciate rather than depreciate. One such circumstance was Indiašs comfortable current account deficit in recent years, including in 1999-2000. Even though oil prices rose sharply that year and substantially increased Indiašs oil import bill, non-oil imports remained sluggish. This was because the much touted recovery in the industrial sector did not prove strong enough to increase the demand for capital goods, components and intermediates, despite the increase in the import intensity of domestic production. On the other hand remittances and earnings from software exports rose, keeping the current account deficit under control. The resulting low level of the current account was itself enough to contribute to stability in the value of the rupee.
But that was not all. The year 1999-2000 was one in which foreign investment inflows into the country , having fallen from $5.4 billion in 19997-98 to $2.4 billion in 1998-999, rose once again to touch $5.2 billion. This volatility was not on account of fluctuations in the volume of foreign direct investment. In fact, foreign direct investment after having peaked at $3.6 billion in 1997-98, has fallen consistently to $2.5 billion in 1998-99 and $2.2 billion in 1999-2000. The fluctuations were on account of sharp variations in the volume of portfolio investments in the form of ADR/GDR issues, foreign institutional investment and investment by offshore funds. The volume of such investments, which fell from a net inflow of $3.3 billion in 1996-97 to $1.8 in 1997-98 and a negative (outflow) of $0.06 billion in 1998-99, rose sharply to $5.2 billion in 1999-2000.
This should have strengthened the rupee further. That did not happen because of the RBIšs decision to buy dollars, increase the demand for that currency and stabilise its value vis-ā-vis the rupee. Net purchases of foreign currency from the market by the Reserve Bank of India amounted to $3.25 billion between end-March 1999 and end-March 2000. These purchases resulted, among other things, in an increase in the foreign currency assets of the central bank from $29.5 billion at the end of 1998-99 to $35.1 billion at the end of 1999-20000. The large demand for dollars that this intervention by the RBI in foreign exchange markets resulted in help keep the rupee relatively stable during financial year 199-2000. In fact, RBI figures show that the real effective exchange rate of the rupee remained more or less constant during 1999-2000, though, as argued earlier, some depreciation of the real effective rate could have helped.
It is this recent history which makes the recent downward movement in the value of the rupee and the RBIšs knee-jerk reaction to it a bit surprising. It is indeed true that over the first two months of 1999-2000, for which we have information, while exports have staged a recovery, imports have grown even faster, resulting in an increase in the trade deficit relative to the corresponding period of the previous year. But what has been a more depressing influence on the rupee are signs that portfolio investments are once again turning negative, and rapidly so. Net FII investments, which in April stood at $617 million, fell to $111 million in May, and turned negative as of June. Outflows are estimated at $218 million in June and around $300 million in July.
It must be noted that net outflows do not reflect a complete loss of FII interest in India. Rather FII purchases during 2000 have been fairly high. But so have sales. In the net, these institutional investors appear to be cashing in their past investments, making some new investments and diverting the rest to other markets. In particular the strengthening of interest rates in the US and the recovery of markets elsewhere in Asia have, according to insiders, resulted in a shift of FII focus away from India. The point is that this consequence of developments elsewhere has had a dampening effect on the value of the rupee, which is perceived as being "overvalued".
From the Reserve Bankšs point of view this should have been fine, except that given the liberalised nature of financial markets, any perception that a currency is overvalued and that it is headed downwards sets off speculation in the currency. The typical form this would take would be the acquisition of rupees that are used to purchase dollars, which in turn are later sold for a much larger sum. So long as this difference is greater than the interest costs incurred on the original amount at prevailing interest rates, the transaction yields a profit.
The difficulty is that transactions of this kind by increasing the demand for dollars, strengthens the dollar relative to the rupee to an even greater extent, ensuring that speculative expectations are realised. It is obvious that the RBI, based on past experience, expected at least some of those authorised to deal in foreign exchange to behave in this manner. This raises the possibility that a warranted and welcome depreciation of the rupee can soon turn into collapse, which can have a host of adverse implications. It is only that perception that can explain the heavy-handed response of the central bank.
The source of that perception could have been evidence that the RBIšs strategy of Œplaying the marketš was proving inadequate to stabilise the rupee. Figure on foreign exchange reserves reveal that the foreign currency assets of the RBI fell by $1.4 billion between end-March 2000 and mid-July 2000. Sensing a downward pressure on the rupee the RBI was clearly offloading dollars in the market with the aim of strengthening the rupee. It was possibly when this proved inadequate to halt an accelerated slide of the rupee that the decision to reverse the direction of monetary policy was taken.
It is to be expected that industry would be affected adversely by the hike in interest rates and the squeeze in liquidity, since it occurs at a time when industrial growth still remains sluggish and the demand for consumer durables has weakened. This only suggests once again that financial liberalisation, which makes monetary and fiscal policy the victim of the whims of highly mobile and speculative portfolio investors, is in the long run inimical to the development of the real, commodity producing sectors. But there is more to learn from these developments. It also makes clear that the defence of financial reform on the grounds that it would help create an autonomous central bank and increase the effectiveness of monetary policy is completely misplaced. The size of the foreign currency assets of the RBI, which is a crucial influence on money supply, is clearly determined by the whimsical behaviour of the foreign financial investor. And there are times when adjustments in the foreign assets position of the central bank is inadequate to realise an objective, necessitating changes in crucial parameters determining the central bankšs monetary stance. This renders all talk of autonomy of the central bank meaningless. While the central bank in India may have won a degree of independence from the scrutiny and influence of the executive and, more crucially, of Parliament, it now appears to have subordinated itself to the requirements of international finance. It is not autonomy that has been won, but a new master.
This sudden reversal in policy came as a reaction to an acceleration of the hitherto gradual depreciation in the value of the rupee. The rupee, which traded at 43.66 to the dollar at the beginning of May 2000, fell to 44.58 by the end of that month and stood at 44.7 around the middle of July. , The RBIšs announcement came when this gradual depreciation gathered momentum, leading to a 15 paise intra-day fall in the value of the rupee relative to the dollar, which took it below the psychological milestone of Rs. 45 to the dollar. The RBIšs Bank Rate and CRR hike came as a swift reaction aimed halting this accelerated depreciation.
There are three ways in which a squeeze in liquidity and a hike in interest rates can affect the dollaršs value in a relatively free foreign exchange market. To start with, in the medium term, it could do so by affecting the level of economic activity. The higher cost of and reduced access to finance would, by curtailing debt incurred to sustain current operations and undertake investment, dampen economic activity and reduce import demand. The consequent improvement in the trade and current account balances, if any, can strengthen the rupee. Secondly, by setting a higher floor to interest rates, the hike in the Bank Rate could increase returns earned by financial investors, thereby attracting financial inflows from abroad. The consequent increase in dollar supply in domestic foreign exchange markets could prop up the rupee. Finally, by making access to rupee resources more difficult and more expensive it can discourage speculators from borrowing rupee funds to speculate on the dollar. To the extent that speculation is responsible for the depreciation of the rupee, this would serve to strengthen the currency.
The intent of the RBIšs manoeuvre is thus clear. What is puzzling, however, is the reason why the observed decline in the value of the rupee, which should be considered Œnormalš in the world of "market-determined" exchange rates that financial liberalisation has put in place, should have invited such a knee-jerk reaction. In fact, there are many who believe that there is a strong case for rupee depreciation. To start with, the dollar has in the recent past appreciated substantially against the currencies of other developed countries, and if the rupee remains stable vis-ā-vis the dollar, Indiašs competitiveness in developed country markets (other than the US) would be affected adversely. Further, even though exchange rates in East Asia have risen from the troughs they reached during the financial crisis of 1997-98, they are still well below their pre-crisis levels. This has given exporters from these countries, which are Indiašs competitors in world markets, an advantage. For these and other reasons, rupee depreciation appeared warranted, especially since trade liberalisation had rendered the use of subsidies as a measure of promoting exports difficult.
In practice, however, an unusual combination of circumstances had ensured that the rupee was under pressure to appreciate rather than depreciate. One such circumstance was Indiašs comfortable current account deficit in recent years, including in 1999-2000. Even though oil prices rose sharply that year and substantially increased Indiašs oil import bill, non-oil imports remained sluggish. This was because the much touted recovery in the industrial sector did not prove strong enough to increase the demand for capital goods, components and intermediates, despite the increase in the import intensity of domestic production. On the other hand remittances and earnings from software exports rose, keeping the current account deficit under control. The resulting low level of the current account was itself enough to contribute to stability in the value of the rupee.
But that was not all. The year 1999-2000 was one in which foreign investment inflows into the country , having fallen from $5.4 billion in 19997-98 to $2.4 billion in 1998-999, rose once again to touch $5.2 billion. This volatility was not on account of fluctuations in the volume of foreign direct investment. In fact, foreign direct investment after having peaked at $3.6 billion in 1997-98, has fallen consistently to $2.5 billion in 1998-99 and $2.2 billion in 1999-2000. The fluctuations were on account of sharp variations in the volume of portfolio investments in the form of ADR/GDR issues, foreign institutional investment and investment by offshore funds. The volume of such investments, which fell from a net inflow of $3.3 billion in 1996-97 to $1.8 in 1997-98 and a negative (outflow) of $0.06 billion in 1998-99, rose sharply to $5.2 billion in 1999-2000.
This should have strengthened the rupee further. That did not happen because of the RBIšs decision to buy dollars, increase the demand for that currency and stabilise its value vis-ā-vis the rupee. Net purchases of foreign currency from the market by the Reserve Bank of India amounted to $3.25 billion between end-March 1999 and end-March 2000. These purchases resulted, among other things, in an increase in the foreign currency assets of the central bank from $29.5 billion at the end of 1998-99 to $35.1 billion at the end of 1999-20000. The large demand for dollars that this intervention by the RBI in foreign exchange markets resulted in help keep the rupee relatively stable during financial year 199-2000. In fact, RBI figures show that the real effective exchange rate of the rupee remained more or less constant during 1999-2000, though, as argued earlier, some depreciation of the real effective rate could have helped.
It is this recent history which makes the recent downward movement in the value of the rupee and the RBIšs knee-jerk reaction to it a bit surprising. It is indeed true that over the first two months of 1999-2000, for which we have information, while exports have staged a recovery, imports have grown even faster, resulting in an increase in the trade deficit relative to the corresponding period of the previous year. But what has been a more depressing influence on the rupee are signs that portfolio investments are once again turning negative, and rapidly so. Net FII investments, which in April stood at $617 million, fell to $111 million in May, and turned negative as of June. Outflows are estimated at $218 million in June and around $300 million in July.
It must be noted that net outflows do not reflect a complete loss of FII interest in India. Rather FII purchases during 2000 have been fairly high. But so have sales. In the net, these institutional investors appear to be cashing in their past investments, making some new investments and diverting the rest to other markets. In particular the strengthening of interest rates in the US and the recovery of markets elsewhere in Asia have, according to insiders, resulted in a shift of FII focus away from India. The point is that this consequence of developments elsewhere has had a dampening effect on the value of the rupee, which is perceived as being "overvalued".
From the Reserve Bankšs point of view this should have been fine, except that given the liberalised nature of financial markets, any perception that a currency is overvalued and that it is headed downwards sets off speculation in the currency. The typical form this would take would be the acquisition of rupees that are used to purchase dollars, which in turn are later sold for a much larger sum. So long as this difference is greater than the interest costs incurred on the original amount at prevailing interest rates, the transaction yields a profit.
The difficulty is that transactions of this kind by increasing the demand for dollars, strengthens the dollar relative to the rupee to an even greater extent, ensuring that speculative expectations are realised. It is obvious that the RBI, based on past experience, expected at least some of those authorised to deal in foreign exchange to behave in this manner. This raises the possibility that a warranted and welcome depreciation of the rupee can soon turn into collapse, which can have a host of adverse implications. It is only that perception that can explain the heavy-handed response of the central bank.
The source of that perception could have been evidence that the RBIšs strategy of Œplaying the marketš was proving inadequate to stabilise the rupee. Figure on foreign exchange reserves reveal that the foreign currency assets of the RBI fell by $1.4 billion between end-March 2000 and mid-July 2000. Sensing a downward pressure on the rupee the RBI was clearly offloading dollars in the market with the aim of strengthening the rupee. It was possibly when this proved inadequate to halt an accelerated slide of the rupee that the decision to reverse the direction of monetary policy was taken.
It is to be expected that industry would be affected adversely by the hike in interest rates and the squeeze in liquidity, since it occurs at a time when industrial growth still remains sluggish and the demand for consumer durables has weakened. This only suggests once again that financial liberalisation, which makes monetary and fiscal policy the victim of the whims of highly mobile and speculative portfolio investors, is in the long run inimical to the development of the real, commodity producing sectors. But there is more to learn from these developments. It also makes clear that the defence of financial reform on the grounds that it would help create an autonomous central bank and increase the effectiveness of monetary policy is completely misplaced. The size of the foreign currency assets of the RBI, which is a crucial influence on money supply, is clearly determined by the whimsical behaviour of the foreign financial investor. And there are times when adjustments in the foreign assets position of the central bank is inadequate to realise an objective, necessitating changes in crucial parameters determining the central bankšs monetary stance. This renders all talk of autonomy of the central bank meaningless. While the central bank in India may have won a degree of independence from the scrutiny and influence of the executive and, more crucially, of Parliament, it now appears to have subordinated itself to the requirements of international finance. It is not autonomy that has been won, but a new master.
© MACROSCAN 2000