The
Indian rupee stood at a robust Rs. 44.4 to the dollar
at the beginning of the second week of April. At that
level the rupee had appreciated by more than 13 percent
vis-a-vis the dollar over the preceding 13 months
(Chart 1). This suggests that the Reserve Bank of
India has not intervened in the market and bought
up surplus foreign exchange to the extent required
to relax the upward pressure on the value of the rupee
and stall its appreciation. This reluctance could
partly be because, given the relatively high level
of already accumulated foreign exchange reserves,
the central bank is finding it difficult to match
the surge in capital inflows with new purchases.
Chart
1 >> Click
to Enlarge
The surge in capital inflows is explained largely
by developments on the supply side, with India being
chosen as one of the favoured destinations by financial
investors seeking to exploit the cheap liquidity that
developed country governments have pumped into the
system in response to the financial crisis. Further,
like many other emerging markets, India is becoming
a victim of the dollar carry trade, in which international
players borrow in dollar markets, where liquidity
is ample and interest rates are low because of anti-crisis
measures, and invest in equity, debt and real estate
in emerging markets, where returns are much higher,
in order to profit from the differential between the
cost of debt and the return on investment. This is
a game that seems to especially attract international
financial firms seeking to quickly recoup the losses
they suffered in the recent recession.
That this kind of game is currently popular with respect
to India as well is clear from the fact that the rupee's
appreciation is associated with a boom in equity markets
driven largely by foreign institutional investment,
as a result of which the Sensex is courting the 18,000
level once again. Balance of payments data recently
released by the Reserve Bank of India indicate that
net portfolio investment inflow during April-December
2009 amounted to $23.6 billion, as compared with an
outflow of 11.3 billion during the crisis months of
April-December 2008 (Chart 2). The accumulation of
reserves during the April-December 2009 period amounted
to $31.5 billion. While valuation changes contributed
to an increase in dollar reserve figures, the importance
of portfolio inflows and central bank intervention
in currency markets cannot be denied.
This process has since continued. According to figures
from the Securities and Exchange Board of India, as
of April 11, net investments by FIIs in debt and equity
markets amounted to an additional $10.1 billion, during
2010. Seen in this light, the reluctance of the RBI
to intervene adequately to absorb these inflows is
understandable.
Chart
2 >> Click
to Enlarge
This
trend reflective of the dollar-carry trade feeds on
itself for two reasons. First, it is well known that
despite post-liberalisation buoyancy the Indian stock
market is still both narrow and shallow. Narrow because
there are relatively few listed companies whose stocks
are actively traded. And shallow because the proportion
of ''free-floating'' shares in these companies not
held by promoters and available for regular trading
is limited. As a result whenever there is even a minor
surge in foreign institutional investment flowing
into these markets, the demand they generate at the
margin is enough to drive stock prices up quite quickly,
widening the differential between the cost of borrowing
and the return on investment and attracting further
investments. This tends to generate a self-reinforcing
and often speculative spiral of investment.
Chart
3 >> Click
to Enlarge
Secondly, the expected return to the investor is even
higher than this differential because as and when
she decides to sell financial assets to book profits
and repatriate capital to clear debts incurred at
home, the appreciation of the rupee yields more dollars
than would have been the case at the exchange rate
when the investment was first made. This provides
an additional return that justifies even more the
speculative spiral and leads to further appreciation
of the rupee.
The corollary of such rupee appreciation is of course
a weakening of India's export competitiveness because
the dollar values of the country's exports rise as
the rupee appreciates. It is to prevent or moderate
that outcome that central banks have to manage the
exchange rate through open market operations, involving
in this case the purchase of dollars and an increase
in reserves. But if this increase in the assets of
the central bank is not neutralised or sterilised
through the sale of government securities, for example,
then money supply to the economy increases. In the
past the Reserve Bank of India had resorted to this
option to retain its control over the pace of expansion
of money supply. But with the inflow of capital having
risen sharply and been quite high in most years of
this decade, its ability to do so depended on rebuilding
its depleted stock of government securities through
special schemes like the Market Stabilisation Scheme
which create their own problems. So the reluctance
to intervene may be because of a decision to retain
some degree of control over the monetary lever ignoring
(at least for some time) the fall out for the rupee.
Whatever be the explanation for that reluctance, it
is material only because as of now dealing with the
source of the problem, which is the embarrassingly
large and unneeded inflow of foreign capital for what
are speculative investments, is not an option for
the government and the central bank. Some other countries,
like Brazil, have sought to deal with the recent surge
with measures, however limited, that are directed
at curbing speculative inflows. Since this would go
against the grain of the ideology influencing economic
reform, which includes the belief that maintaining
a freer and more open capital account is the best
option, the Reserve Bank of India that wants control
over the monetary lever and is faced with a surge
in capital inflows would have to tolerate rupee appreciation.
Chart
4 >> Click
to Enlarge
But it is clear that the central bank cannot continue
with this stance for long. India's balance of payments
statistics point to high and persisting trade and
current account deficits in recent quarters (Chart
3 and 4), and those deficits would only widen if international
oil prices continue to rise. In these circumstances,
even if the protests of exporters are dismissed, a
process that renders exports more expensive in dollar
terms and imports cheaper in rupee terms cannot be
ignored. That is ''success'' on the capital account
of the balance of payments cannot beyond a point be
at the expense of a weakening of the current account
and the domestic economy.
Further, rising inflation is forcing the Reserve Bank
of India to turn its attention to what has always
been its primary brief: using the monetary level to
moderate price increases. One way in which it is expected
to do this is by raising interest rates and reducing
offtake of credit to cool an overheating system. But
raising domestic interest rates would only encourage
further those investors exploiting international interest
rate differentials and engaging in the carry trade.
Being relevant on the price management front may make
the central bank an even greater failure with regard
to exchange rate management.
The real option is, therefore, one of dealing with
the source of the problem and using measures to control
the inflow of financial capital, especially speculative
capital. There are many policy options at hand to
achieve this end. What is required is that a government
that had perceived the surge in capital inflows and
the accumulation of reserves as being indicators of
economic success admits that even in its own framework
this is proving to be too much of a good thing.
