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'No' to convertibility - Views on News from Equitymaster
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  • Aug 10, 1997

    'No' to convertibility

    On 11 July, the governor of the Central Bank of the Philippines threw in the towel. No, Mike Tyson did not bite off his ear, but international punters had taken a bet that the Philippine peso would devaluate and, after weeks of putting up a fight, the governor gave up: the peso had fallen by 11 per cent. Just a few weeks ago, punters had made a bet against the Thai currency and won that too: the baht was devalued by 18 per cent. Reports from Thailand suggest government officials are furious because they believe that it was negative economic reports written by foreign broking houses that led to the (in their view) unnecessary plunge in their currency.

    After having spent five years on the reform process, the Reserve Bank of India (RBI) has been inspired to draw up a game plan for convertibility of the currency: that is, money will be free to flow out of, or into, India at any time for any purpose at a rate determined by the market. The irony of the timing of the RBI's decision to show India's strength is spectacular, given the plunge in the exchange rates of our neighbours. Sure, one has read enough about plummeting property prices and bank failures that may justify the fall in the Thai baht. and one has read a fair bit about expectations of a similar problem in the Philippines. And we have been told by everyone that India is different - the key phrase again - and will not face the same problems. In the past two years, it is the Indian rupee that has lost 10 per cent, and recovered its composure only because it is still a controlled currency.

    But can anyone guarantee that the rupee will survive another onslaught ? Can anyone guarantee that there will be no expectation (and that is the catch word) of a crisis in India. In the glorious country that we live in an expectation of a crisis can be triggered off by: a garland around a statue, the discovery of yet another scam.... the list is endless. And it is these expectations that lead to attacks on currencies.

    Yes, hedge funds and punters have these meticulously planned swoops with guns blazing and armoured cars and missiles for cover, based on ground statements and assumptions that lead to self-fulfilling prophecies. The power of a combination of assumptions and weight of money can be devasting - on the upside or the downside. Expectations of a disaster can be lead to the disaster itself! Just after the CRB scam every non-bank finance company (NBFC) was scared of being the next casualty not because they had problems but, rather, because many perceived that they had problems, leading to the problem itself. Here is what a fund manager in London had to say about the next target of the hedge funds, the Malaysian ringitt: "The ringitt is going to be attacked. Fundamentals don't necessarily argue for Malaysia to devalue but currency markets have got in their heads and they will try it out." Are you ready for them. Mr. central banker?

    If every depositor believes that there is a problem with a company or institution and if they collectively walk to their nearest NBFC or nationalised bank and demand their money back, you are going to have a problem - a financial failure - because no one keeps cash in their bank vaults. Money received from depositors is lent out to borrowers, so if every depositor is going to ask for their money back across the counter, the institution will not have cash in their vaults to pay it. It is this same expectations theory that drives stockmarkets and currency markets.

    The amount of foreign currency traded today is over 100 times the value of underlying goods and services which are exchanges around the world everyday. The forex market are very speculative. And volatile. Add to this the recent birth of the hedge fund: pools of money that are out to maximise profit from any activity, be it investing in gold, pork bellies, orange futures, currencies, stocks - you name it, they can buy it. Or sell it. In large amounts. For short duration's. For an opportunity to make lots of money.

    Now put India's noble objective in perspective: we want to allow money to move in or out in an environment where expectations of big-betting hedge fund managers can determine the value of our currency - and hence our economic policy. Some supporters of convertibility are willing to bet that this traditional measure of having six months of import cover as our forex reserves (now at $29 billion and eight months of import cover) is sufficient to ride this great economic experiment of floating our currency to the whims and fancies of invisible forex traders and punters.

    Many of you have probably just returned from an overseas vacation. But next year, after you have faced the embarrassment of begging for a visa to be imprinted on your Indian passport, ask your travel agent or friendly foreign banker to arrange to visit to the trading floor of their exchange division. When you arrive at the forex dealing floor of this foreign bank in London or New York, make a note of the age of the dealers and listen to their conversation as they punt in million of dollars of currencies. On the exotic currency desk (that means Thailand, Philippines, India and other exotic countries) you may ask any of the dealers to spell the names of the countries in whose currencies they trade. Chances are that Philippines will have a few more "I's" than necessary. Being twenty-something, spelling is not essential: having the balls to take big bets is the criterion for being an forex dealer.

    As you leave that room, keep this in mind: the guys on those desk, with their actions of buying and selling currencies, affected the lives of roughly 3 billion people in these exotic economies. Many of them will not have a clue of the GDP, illiteracy, poverty, or hassles that many of these 3 billion people face in their struggle for daily survival. I don't blame them, for that is not their job. Their job is to make money buying or selling a currency.

    Don't get me wrong. Having a convertible currency is great. I would love to sell my over-priced property in South Mumbai and swap it for a better quality and higher place outside India and still have money in the bank. And I would love to sell some of these overpriced shares in India and buy cheaper stocks abroad. And it is nice to say that we should have a 3.5 percent budget deficit (why not no deficit?) or a 3-5 per cent rate of inflation before we get to do all these fun things and be traded as an exotic currency. These are all numbers and there is nothing sacrosanct about them. The biggest precondition, in my view, is to have the political and social agenda in place.

    What we want as a country - not as mandarins in the ministry of finance and RBI - needs to be clearly defined, documented, and agreed upon. We work towards that goal. And then, after all this is done we can talk about convertibility not because it is the economic fashion of the day or because someone else has done it, but because we can afford it.



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