Rupee instability

Financial liberalisation has dissociated the rupee's movement from fundamental trends in the current account of the balance of payments.

THE behaviour of the rupee during the week ending Friday, August 22, took Prime Minister Inder Kumar Gujral by surprise. On August 20, The Economic Times front-paged an interview with him in which he stated that the Government was working on a band within which the exchange rate of the rupee vis-a-vis the dollar would be free to fluctuate. That innocuous statement triggered an unexpected response in the foreign exchange markets: on August 20 itself, the rupee slipped sharply and moved down from 35.70 to the dollar to 36.16.

Sensing the panic, the Reserve Bank of India (RBI) issued a clarification to the effect that no decision had been taken on the recommendation of the Tarapore Committee on Capital Account Convertibility (CCAC) to institute a band in relation to a neutral exchange rate. However, the slide of the currency persisted through the next two days, and the rupee closed at 36.25 and 36.60 to the dollar on August 21 and August 22. As a result, the depreciation over a three-day period amounted to 2.4 per cent. The downward pressure on the rupee continued during the subsequent week, despite an effort on the part of the RBI to sell dollars from its reserves to moderate the decline of the rupee against the dollar.

Until quite recently, the fundamental tendency in India's liberalised foreign exchange market was for the rupee to appreciate owing to an excess supply of dollars relative to demand. Supply was high because of inflows on the capital account, principally in the form of portfolio flows and borrowing by Indian firms, and demand was low because of the recession-induced sluggishness in import growth. As a result, central bank intervention, in the form of the purchase of dollars that raised demand for the currency, was necessary to prevent the rupee from appreciating against the dollar. A little more than a fortnight prior to the rupee's recent slide, on August 1, the rupee had appreciated in a single day from 35.705 to the dollar to touch 35.82, before closing at 35.77.

If despite such pressures the rupee had traded at a price ranging from 35.70 to 35.85 to the dollar over the last year, it was only because of intervention by the RBI and its purchase of dollars that were added to its reserves. The RBI's purchases during the first four months of this financial year (April-July) amounted to $4.6 billion. Similar purchases in the past had resulted in a situation where the central bank's foreign currency assets rose by $8.32 billion in a year, to touch $26.21 million on August 14.

Initially the Government portrayed this rise in assets as an indicator of the success of its economic reform, which began in the wake of a collapse of such reserves. However, three trends have given it cause for concern in recent times. First, signs of a sharp slowdown in exports. Not only had the rate of growth of exports in dollar terms fallen from 20.8 per cent in 1995-96 to 4.1 per cent in 1997-98, but exports during the first two months of this financial year have fallen absolutely, recording a negative 1.63 per cent rate of growth relative to the corresponding period of the previous year.

For a Government pursuing a strategy whose success is essentially dependent on a massive spurt in exports, this cannot but be disconcerting. While there are a host of factors responsible for this slowdown, including a deceleration in world trade growth and the lack of foreign investment that uses India as a location for world market production, exporters have focussed on the exchange rate as the cause of their loss of competitiveness. An "overvalued" rupee, it is argued, increases the dollar price of India's exports.

The exchange rate and its possible effects on export performance have been sources of concern for the Government as well. Official figures suggest that the real effective exchange rate of the rupee, which weights the rupee values of different currencies by India's exports to those currency areas and adjusts for differences in the rate of domestic and world inflation, has appreciated by about 11 per cent between January 1996 and April 1997. That appreciation has been noted both within and outside the Government. Days before the rupee's slide, the Deputy Governor of the RBI had announced to a gathering of foreign exchange dealers that the rupee was in fact overvalued.

Implicit in that announcement was a statement that the Government and the RBI were thinking about ways in which the upward pressure on the rupee stemming from liberalisation-induced capital flows could be reversed. But with the task of keeping even the nominal value of the rupee relatively stable involving huge dollar purchases by the RBI, the Government has found its hands virtually tied. Besides the fact that, from a national point of view, rising reserves amounts to borrowing at a higher rate of interest to invest in liquid low interest instruments, the rupee expenditure associated with such purchases increases the supply of money in the economy. Given its monetarist perspective, and its belief in the importance of controlling money supply in pursuit of non-inflationary growth, the RBI found that outcome to be troublesome.

The third source of concern is the slowdown in import growth despite import liberalisation because of an industrial recession. Imports, which grew by 23 per cent and 28 per cent respectively in 1994-95 and 1995-96, slowed to just 5 per cent in 1996-97. More recently, the country's imports have grown by a meagre 0.05 per cent during the first two months of this financial year compared with the corresponding period of the previous financial year. Thus, while the inflow of foreign exchange on the capital account has been high and rising, the outflow on account of imports has been sluggish, contributing to the upward pressure on the rupee. A high growth of imports when exports are sluggish would have implied a rise in the trade deficit, which have already risen from $2.3 billion in 1994-95 to $4.9 billion in 1995-96 and 5.4 billion in 1996-97. However, it is clear that the Government sees that as less of a problem in the short run, since the trade deficit is easily financed by buoyant capital inflows. The long run, in its view, can take care of itself.

PERHAPS inadequately informed about this fragile state of India's balance of payments and unfamiliar with the capriciousness of forex traders, Gujral chose to give one more of his candid interviews to a financial journalist - this time on the immediate economic challenges facing the country. Among the issues on which he discoursed was the threat of rupee appreciation because of large foreign capital inflows and its consequences for the competitiveness of India's exports. Accepting that one of the factors influencing India's poor export record in recent times could be the appreciation of the rupee, the Prime Minister spoke of two kinds of exercises which were under way. One is to find judicious ways to utilise and reduce India's record foreign exchange reserves, accumulated through purchases by the RBI to stem the rise of the rupee. The other is to set a band within which the value of the rupee vis-a-vis the dollar would be allow to fluctuate freely.

That these initiatives were being seriously considered was never a secret: the demand that high reserves warranted freer imports of consumer goods and greater freedom to access foreign exchange for investment abroad has been periodically voiced by sections outside and within government; and the agenda that the CCAC had set for the immediate future included the institution of a band within which the rupee would be free to fluctuate.

However, possibly because of the high office that he occupies, Gujral's statements had an electrifying effect on the market. The signal which the market received from his transparency with regard to policies under formulation ostensibly was that the Government was keen to let the rupee depreciate. However, rapid depreciation sets off expectations of further devaluation, which has three kinds of effects. First, it makes foreign investors hold back on even intended purchases, since the dollar value of the financial assets they purchase would fall in the wake of currency depreciation. Secondly, it encourages speculative shifts in currency holdings away from the rupee to the dollar, aggravating the downward pressure on the rupee.

Finally, it creates uncertainties that are compounded by evidence that the fundamentals of the economy are weak, which can set off a process of capital flight on the part of foreign institutional and non-resident investors as well as exporters who are bound to delay repatriation of their dollar earnings. These factors can make the rupee's slide unstoppable. If a downslide of this kind, witnessed in Latin America in the past and in South-East Asia more recently, is triggered, the record foreign exchange assets of the Government would prove small change in the effort to stem the collapse of the rupee.

Instability of this kind is inevitable because financial liberalisation has dissociated the movement of the rupee from fundamental trends in the current account of the balance of payments. While slowing exports and a rising current account deficit, on the one hand, and the depreciation of currencies of India's developing country competitors, on the other, suggest that the rupee should find a new lower level, capital account inflows into liberalised financial markets contribute to an appreciation of the currency. This suggests that, even if the belief that economic liberalisation in the form of liberalisation of trade and foreign investment regulations would spur exports is accepted for the sake of argument, governments seeking a larger presence in world markets for their own industry should go slow on financial liberalisation. Only when trade fundamentals are strong should any liberalisation of the financial sector be experimented with.

However, international pressure in recent years through official and private institutions has focussed on financial liberalisation, given the rise to dominance of finance capital in the international economy. The Government succumbed to that pressure partly because of its choice of two soft options. First, a decision to provide international private capital a greater role in its growth so as to avoid more fundamental structural reform and avoid having to discipline domestic economic agents directly rather than through the market. Secondly, a desire to use the short run benefits of volatile portfolio capital flows to tide over balance of payments difficulties without resolving them.

Having, for these reasons, vacated the economic space over which it exercised some control in the past, it is not surprising that the Government finds itself without any room for manoeuvre. Since Gujral goes along with the policy of leaving everything to the market, the markets have told him to sit by and watch for the denouement rather than speak of making the system work using new policy initiatives.