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In Favour Of Instability

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Whether they lost or not, the FIIs that sold out were allowed to escape without any loss on exchange, for the Rupee held up like a rock. Banks hold some inventories of foreign currency, but if they had been left to themselves, they could not have coped with the flight of billions within two days. They must have called up Reserve Bank of India and asked for dollars; and Reserve Bank evidently complied. For Reserve Bank believes in stability. Letting the Rupee slide would have been a sign of instability, which in central bank jargon is a form of dementia.

Imagine for a moment, however, that Reserve Bank had refused to part with dollars when the banks ran to it for succour; what is the worst that would have happened? The dollar might have shot up to Rs 60. The Rupees that the FIIs got by selling their shares would have been converted into much fewer dollars. The sell-off led to a 15 per cent fall in Sensex. If a 33 per cent fall in the exchange rate had coincided, the FIIs would have taken a loss of 44 per cent in dollar terms. Not all would have; if they had faced a falling Rupee, some of them would have stopped selling much earlier, and Sensex would have fallen much less. Indian investors, whose investments are almost entirely in Indian shares, would have taken a smaller loss, and foreign investors greater.

So from an Indian point of view, a flexible exchange rate would have been better than the adjustable peg that Reserve Bank operates. How about tomorrow, when those timid FIIs creep back in? When they re-enter the market, their dollars would lead the Rupee to appreciate; they would have to spend more dollars for the same shares. That might put some off the Indian market. But the Indian ministers of finance and commerce have been shouting from mountain tops in Davos that India is going to go on shining and glittering forever, whatever happens to America. If they are right, there is nothing to worry about. Sooner or later, those cowardly FIIs would creep back, and share in our perennial feast.

Hence so as far as the stock market is concerned, a flexible exchange rate would be good for India. Why, then, is Reserve Bank so against it? Is a managed peg better for exports and imports? If India were on a dollar exchange standard like Hong Kong, or even on a Euro exchange standard, people would forget exchange risk and trade as readily with foreign countries as they do within India. Foreign trade would grow faster; India would become a more open country. But it would do so only if Reserve Bank burnt its 2000-page book of exchange controls and let us transact as freely with foreigners as we do amongst ourselves. And an exchange standard would work only if we were considerably more disciplined in our domestic policies. We would have to run a responsible fiscal policy and keep inflation under control.

But such hardships would be necessary only if Reserve Bank simply could not keep away from its sport of exchange rate stability. In the absence of a managed exchange rate, inflation would simply lead to depreciation of the Rupee. If the government was profligate and wanted to borrow too much or pay too little for it, it would find no lenders; Indians would invest in German bonds instead. So the government would be forced to live within its means. It could run a deficit by issuing currency; but that would increase the supply of Rupees relative to foreign currencies, lead to depreciation of the Rupee and cause inflation. That would be no problem, however, since Reserve Bank would not have to support the exchange rate. If it did not have to support the exchange rate, Reserve Bank would have no use for the billions of dollars of foreign exchange. They could be sold off; out of the proceeds, the government could give us a few years’ tax holiday.

There is, therefore, a case for taking a holiday from exchange rate management and letting the Rupee float. It may lead to exchange rate volatility, but surely it will be no greater than the stock market volatility we have to bear.

(Businessworld Issue 05 - 11 February 2008)

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