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Macroeconomic Perspectives In Volatile Forex Markets
Jun 28, 2013

Address by S.S.Tarapore at the Dun and Bradstreet-Citibank Event on Managing International Trade and Foreign Exchange Risks in Today’s Market on Thursday, June 27, 2013 at Bengaluru

Today's event, organised by Dun & Bradstreet and Citibank, is relevant as global growth rates continue to be below trend line and Emerging Market Economies (EMEs) are facing problems in their interface with the global economy. In India, the official line is one of morale building that things are under control, but if there is an inappropriate choice of policies, India can be in a serious crisis which will make the 1990-91 crisis seem like a pleasant tea party.

A Maverick Perspective of the Global Economy

2. There has been a distinct slowdown in the global economy since the international financial crisis of 2008. Despite five years of unbridled pump priming, the global recovery is still illusive. The latest IMF forecasts show that industrial countries, which grew at 1.2 per cent in 2012, are expected to grow at 1.3 per cent in 2013; the pious hope is that they would grow at 2.2 per cent in 2014. While the mainstream view is, that sooner or later the global economy will regain its earlier growth momentum, there is a less traversed viewpoint that global recovery would take an inordinately long time; it is necessary to also give some attention to this maverick perspective.

3. Nicolai Kondratieff, a Russian economist, way back in 1926, came out with a path-breaking work on Long Waves in Economic Life. The major theme of this study was that the capitalist system experiences a 50-60 years long wave cycle of boom and bust. According to Kondratieff, there are four phases of the long cycle: inflationary growth, stagnation, a deflationary plateau and finally depression. At the start of the cycle economies produce high cost capital goods and infrastructure, creating new employment and income and a demand for consumer goods. After some decades the expected return on investment falls below the rate of interest and people refuse to invest as overcapacity in capital goods gives rise to massive outlays reducing the demand for consumer goods. Unemployment and a long economic cycle ensue as economies contract. People and companies tend to save resources until confidence returns and there is an upswing into a new capital formation period, usually characterised by large scale investment. Kondratieff associated these cycles with major technological breakthroughs. There is a sad end to Kondratieff's work as it was considered as a veiled attack on Stalin's policies and he was shot in 1938 and it was only in 1987 that he was rehabilitated.

4. It is admittedly a provocative thought that may be the Kondratieff's long cycle is relevant for the present slowdown in the industrial countries, which after long years of high growth, are now going through stagnation to be followed by a deflationary plateau and finally depression. Policymakers in the industrial countries dismiss the Kondratieff cycle as being irrelevant.

5. The Emerging Market Economies (EMEs) should not presume that their export markets will automatically revive in a short period. As unbridled bouts of pump priming in the industrial countries would reverse in the ensuing months, the EMEs should be prepared for a large exodus of capital.

Recent Indian Macroeconomic Developments

6. India experienced high growth rates of 8-9 per cent before the global crisis but thereafter experienced progressively lower growth rates and ultimately a 5 per cent growth rate in 2012-13. Policy helmsmen try to restore confidence by taking the stance that India would soon return to the halcyon days of over 8 per cent growth rates, retail inflation will fall to 5 per cent, fiscal consolidation would be on track to attain 3 per cent of GDP and the balance of payments current account deficit (CAD) would come down to 2.5 per cent of GDP. Central to the thinking of Indian policymakers is that low interest rates would be crucial to the recovery of Indian growth.

7. The ground reality is that while significant efforts have been made to rein in the fiscal deficit, it still remains high. With relatively easy money and structural constraints, retail inflation is uncomfortably high, at over 9 per cent. With the low interest rate regime, savings have fallen in recent years, by about 5 percentage points of GDP, and the savings-investment gap is reflected in an unsustainable CAD of 5 per cent of GDP.

8. To revive growth, policymakers have opted for a quick fix. The ingredients of such a policy are lower interest rates (advocates of low interest rates would derive strength from the good monsoon) and to defend the exchange rate of the rupee with the erroneous belief that these measures would control inflation and stimulate growth.

9. It may sound excessively pessimistic but what portends for the immediate future is growth not significantly above 5 per cent, retail inflation back to double digits, a fiscal deficit close to 5 per cent of GDP and a CAD of 5 per cent of GDP. A recent study by the National Council of Applied Economic Research (NCAER) has pegged the annual average rate of growth at a mere 4.8 per cent if the current logjam in policy making continues. All this may sound like a horror movie, but a serious possibility is India could be heading to a low level disequilibrium trap.

Tackling the Large CAD

10. With a current receipts to GDP ratio of 25 per cent, the 5 per cent CAD translates to 20 per cent of current receipts which is very sizeable-- we have clearly entered into dangerous waters. We are increasingly dependent on Foreign Institutional Investments (FIIs), External Commercial Borrowing (ECB) and Non-Resident Indian (NRI) Deposits which are extremely volatile and there could be sudden large outflows of capital. Furthermore, it is worrisome that short-term debt (less than one year residual maturity) accounts for 40 per cent of external debt.

11. India's foreign exchange reserves have been stagnant in recent years. As against US $ 310 billion in March 2008, they fell to US$ 292 billion in March 2013. Since current payments have been increasing sharply, the reserves now provide a cover for only six months of current payments as against 12 months a few years ago.

12. While all the major Asian EMEs have faced volatile capital outflows in the recent period, most of these countries have a substantial current account surplus. India with a large CAD is the most vulnerable country in Asia in the event of a massive exodus of capital which is inevitable as the quantitative easing is unwound.

13. The preoccupation of the authorities in India is to secure the financing of the present CAD and this explains the efforts to streamline FDI/ FII inflows. While there have been rumblings on a Sovereign Bond or an NRI Bond, it is a relief that policymakers have put this on the backburner. Such bonds merely result in a switch from present inflows and there would be little additional inflows and moreover, these bonds would be costlier than existing capital inflows. Again, there has been erroneous focus on dealing with gold imports. The raising of the import duty to 8 per cent, restricting sales of coins by banks and curtailing lending against Gold Exchange Traded Funds would not reduce the demand for gold but merely shift the demand from official channels to unofficial channels without reducing the CAD.

14. A relatively low growth, high inflation and a large CAD is a lethal cocktail which could explode at any time. Policy adjustments have been left too late and this is no time for namby- pamby measures.

Analytics of Reducing the CAD

15. Before deciding on appropriate remedial measures it is essential to distinguish between measures to increase capital inflows and measures to reduce the CAD. Given that the present CAD is large, it is legitimate to streamline procedures and facilitate capital inflows but this by itself does not reduce the CAD. The effective policies for reducing the CAD are all hard options. These are: (a) Increase in interest rates and tightening domestic liquidity. (b) Deflating the economy by a severe reduction in the fiscal deficit. (c) Reintroduction of current and capital controls. (d) Adjustment of the exchange rate. Deflation and current/capital controls have many adverse implications and as such the other two options need serious consideration.

Raising Interest Rates and Tightening Money

16. A tightening of monetary policy would be one of the effective ways of correcting a high CAD. There can be a number of ingredients in monetary tightening. An increase in policy interest rates would reduce the reliance on RBI accommodation. A sufficiently large increase in interest rates would attract more capital inflows and reduce the outflow of capital. More importantly, increased interest rates would make the holding of financial assets more attractive and thereby reduce the demand for gold. It is erroneously argued that higher interest rates would dampen industrial activity. This is highly exaggerated. If interest costs are 10 per cent of total costs of production, a one per cent increase in interest rates would raise total costs by 1 per cent. The world over, increase in interest rates is a vital ingredient in reducing the CAD. Furthermore, this needs to be supported by increase in reserve requirements. There is no need to be purists and go by the fashions of the time of not using reserve requirements to tighten money. In fact, a combination of interest rate increases and reserve requirements would be milder than if only interest rates are raised. In addition, the RBI would need to refrain from excessive open market purchases which would be counterproductive as it is in effect monetary easing. In fact, the RBI should undertake a modicum of open market sales.

17. The government believes that reducing interest rates are a panacea for all Indian macroeconomic problems. The contrary is true. An interest rate reduction, far from resolving our current problems, would aggravate the situation. Macroeconomic stability would require that investments are raised while reducing the present gap between savings and investments and this requires a sharp increase in domestic savings which would warrant a sharp increase in interest rates on financial assets.

18. The more immediate problem for the RBI is to ward off pressures from government to reduce policy interest rates on July 30, 2013 (the date of the next monetary policy review).The need of the hour is a swingeing monetary tightening of interest rates and reserve requirements together with open market purchases. This would raise the cost of government borrowing and the government has to accept this as the price for earlier lax policies. In this situation it would be imprudent of the government to continue overt pressures on the RBI to ease monetary policy; any such easing of monetary policy would be a sure prescription for inviting a disaster.

Adjusting the Exchange Rate

19. The global economy, particularly since 1971, has increasingly moved towards sharper movements in exchange rates. It is unfortunate that the exchange rate in India is tangled with political economy issues. A depreciation is interpreted as a failure of macroeconomic policy and an appreciation is treated as a vindication of effective policies. It is no wonder that our macho spirits call for a strong rupee. Hence, for most of the time, India tends to have an overvalued rupee. Such an exchange rate is obviously disastrous for the economy.

20. What is more distressing is that there is an attempt to produce ingenious justification for a strong rupee. It is erroneously argued that a depreciation is inflationary and an appreciation is disinflationary, while the contrary is true. It is unfortunate that in India we ignore the concept of "absorption". If the exchange rate is US $ 1=Rs 50 and it depreciates to Rs 60, then more rupees are absorbed per unit of foreign exchange spent and as such there is a monetary contraction. When the rupee appreciates from, say, Rs 60 to Rs 50, per unit of foreign exchange spent, less rupees get absorbed and as such it results in monetary expansion. With a large CAD an appreciation of the rupee would be suicidal.

Determination of an Appropriate Exchange Rate

21. There are many ways of determining the appropriate exchange rate, though some of these are abstruse theoretical exercises. Given the continued dominance of the US dollar, any assessment of the appropriate exchange rate is best undertaken in relation to the US dollar. As a rule of thumb, India would not be off the mark if it were to maintain the nominal US dollar- rupee rate based on secular inflation rate differentials between the US and India. With a long-term inflation rate differential of say a little over 4 per cent (it would, in all probability, be even higher), using the exchange rate of March 1993 (which was the point of unification of the dual exchange rate) of US $ 1=Rs 31.37 (which remained stable for quite some time), the present appropriate exchange rate would be US $ 1=Rs 70. The mere mention of such an appropriate exchange rate causes consternation in official circles as the Indian polity is wedded to a grossly over-valued exchange rate which is the root cause of the large CAD. An overvalued exchange rate encourages imports and discourages exports. Moreover, it lacks distributive justice in that it is biased in favour of large industry, which is import intensive, and biased against medium, small and tiny industry which is export intensive. Again, an overvalued exchange rate makes imports cheap and often wipes out efficient domestic industry, a case in point being the toy industry.

Ground Rules for RBI's Forex Intervention

22. The RBI should, at this stage, refrain from supporting the rupee by any substantial sales. To the extent, as part of orderly exchange rates, the RBI undertakes spot sales, it should undertake corresponding purchases in the forward market. But any net support to the exchange rate should be ruled out.

23. A basic policy guideline should be to ensure that inflation rate differentials are reflected in the interest rate differentials and the interest rate differentials should be reflected in the forward exchange premium. Thus, to the extent the rupee is overvalued, based on long-term inflation rate differentials, the RBI should refrain from intervening to support the rupee exchange rate. It is not as if one is advocating a purist's approach of never intervening in the forex markets; in fact many industrial countries have, from time to time, undertaken subtle intervention in the forex markets. With the rupee clearly overvalued, fighting a depreciation would be a losing battle particularly as the US dollar is gaining strength in international markets. During the recent period, the exchange rates of most EMEs have depreciated vis-a-vis the US dollar despite most of these countries having a current account surplus. It would be foolhardy of India to defend the overvalued exchange rate, particularly when there is a large and unsustainable CAD. While it is often argued that we should avoid self-fulfilling prophecies, it is necessary to accept the ground realities of misalignment of the rupee. The authorities would do well to accept that the rupee is overvalued and they should let the market go through the adjustment without RBI intervention to support the overvalued exchange rate. As such, the RBI should not support the rupee till it reaches US $1=Rs 70. In fact, when there is an appreciation against fundamentals the RBI should not hesitate to build up its war chest of forex reserves.

24. There is, outside India, a very large rupee Non-Deliverable Forward (NDF) market and the volume of transactions in this market is rising rapidly, with a daily turnover running into billions of dollars. For the RBI to influence this market it would need to trade very large amounts, say on average US $ 5 billion a day. Such a large operation by the RBI would be futile and this is one more reason for the RBI not to defend the rupee. The NDF market exists as certain transactions are not permitted in the Indian forex markets. Sooner or later, the Indian authorities will have to open up the forex market and allow all transactions in the Indian forex market. The problem is that many of these transactions could be purely speculative and could be destabilising. While liberalising transactions in the forex market it is essential that the RBI and market operators have a clear understanding of these operations. There is always the lurking fear of speculators" breaking the Bank". But if the RBI scrupulously avoids supporting an overvalued rupee there should be no danger of such an eventuality.

Strategies for Forex Market Operators

25. A basic dictum for forex market operators with underlying current and capital exposures should be not to keep open positions. The exchange rate, in the in the ensuing period, will be in stormy seas and market operators will do well to concentrate on their primary business and refrain from taking speculative positions,however tempting it may be to do so. All forex operators should, to the extent possible, cover themselves in the forward market. Respected forex market advisers often advise their clients to keep open positions or keep partial open positions. Forex market operators with underlying transactions should never resort to open positions. To the extent they wish to keep open positions they might as well try their luck at the races.

26. For far too long, Indian corporate and others have felt that borrowing abroad is an easy option which also explains the keenness to seek FII investments, ECBs, NRI foreign currency denominated deposits and trade credit. Given that there would be increased turbulence in forex markets Indian operators would be well advised to drastically reduce such liabilities.

The Relevance of Dr. Reddy

27. Dr.Y.V.Reddy has been one of the leading international interlocutors on the global financial crisis and its impact on EMEs, particularly India. Dr. Reddy's rich experienced is distilled in his new path-breaking book on Economic Policies and India's Reform Agenda: New Thinking, Orient Blackswan Private Limited (2013). This book is a master craftsman's treatise on sound macroeconomic policy which will become the locus classicus on the subject. As such, this book should be mandatory reading for all policymakers, financial analysts, market participants and economists with keen interest in the global crisis and its impact on India.

28. Dr. Reddy says that the flawed international monetary system was one of the causes of the crisis and he calls it a "non-system" with no alternatives. It is surprising that with the debauching of all currencies, the international monetary system has not totally broken down.

29. As regards India, Dr. Reddy stresses that it needs to strengthen its buffers against volatility and he lays great store in raising the savings rate, particularly of the household sector. He has concerns about vulnerability of the external sector on current account through shocks on fuel and food prices as also the vulnerability on the capital account emanating from the preponderance of portfolio flows. Dr. Reddy makes a novel and radical suggestion that if the sustainable current account deficit over the medium-term is 2.5 per cent of GDP, which during periods of shock could rise to 5.0 per cent, it is conceivable that international investors may not tolerate this upper level of the CAD. He, therefore makes out a case for a zero CAD over the medium- term so that during periods of shock the deficit could rise to say 2.5 per cent of GDP. EMEs which have grown rapidly during the past 20-30 years have not had a large CAD and in fact many have run current account surpluses. He explains that advocacy of a zero CAD does not mean that the current account to GDP ratio should be small; in fact it could be larger with greater interface with the global economy.

30. Dr.Reddy has a number of interesting observations which are pertinent to India. First, the growth of the global economy will, in future, be less than hitherto. Secondly, global inflation is likely to rise. Thirdly, the enthusiasm for globalisation of finance may be moderated as there are downside risks of global integration. Fourthly, there would be increased tensions in developing countries on sharing of the fruits of development. Fifthly, economic thinking is likely to be more humble and less assertive. Finally, economic policies would be more pragmatic and eschew from corner solutions (the most glaring example is the advocacy that fixed or floating exchange rates are the only viable alternatives and that the trilemma of free capital flows, fixed exchange rates and independent monetary policy has to be resolved and cannot be managed).

31. Dr. Reddy argues that the better and more stable path for India would be to provide incentives for domestic savings. While we all wish for a return to a 9 per cent growth, the only solution is to work harder for it (harder than before).In other words, Dr. Reddy finds that the only way to attain our cherished objectives is to go along with the hard options.

Concluding Observations

32. While concluding it would be useful to recapitulate a few vital issues for policymakers as well as participants in the forex markets.

(i) There is a possibility that the global economy could be afflicted by a long cycle of relatively low growth.

(ii) International capital flows could be more volatile than hitherto and countries like India would be well advised not to finance the CAD through excessive reliance on international markets, particularly portfolio flows. Reducing the present CAD of 5 per cent significantly to say 2.5 per cent should be the topmost priority.

(iii) Since financing a large CAD would be hazardous, a medium-term average CAD of 2.5 per cent of GDP could imply a peak CAD of 5.0 per cent which, in future, the global financial system may not be willing to finance. Hence, the 2.5 per cent CAD should be the upper bound and the medium-term objective should be an average zero CAD.

(iv) An essential ingredient of rectification of the large CAD, would be stepping up the savings rate (particularly household sector savings), by 4-5 percentage points, so as to bring down the gap between the savings and investment rates. This will warrant a substantial and immediate swingeing monetary tightening of interest rates, reserve requirements and open market sales of securities.

(v)Allowing inflation to get out of hand is a sin in a country with large income disparities. Tightening policy is unpleasant but remedial measures are the wages of sin. Control of inflation is vital and the objective should be to reduce retail inflation to 3-5 per cent per annum.

(vi) The exchange rate is still out of alignment despite the correction in the more recent period. The appropriate exchange rate, taking into account inflation rate differentials, would be closer to US $1= RS 70 as against the current rate of over Rs 59. The RBI would be well advised not to defend an unsustainable exchange rate. RBI intervention should be restricted to purchases to avoid excessive appreciation.RBI spot sales should be limited to dampen extremely large movements in a day and this should be matched by purchases in the forward market.

(vii). The inflation rate differentials between the US and India should be reflected in the interest rate differentials and the interest rate differentials should be reflected in the forward premium on the rupee.

(ix) All participants in the foreign exchange market with underlying current and capital transactions should always cover forward. This should apply equally to exporters as well as importers. Participants in the forex market should not be tempted by greed and should refrain from keeping open positions. Participants with underlying current and capital transactions should never become speculators. Taking a speculative position is akin to dancing with the devil which carries risks which are obvious.

Address by S.S.Tarapore at the Dun and Bradstreet-Citibank Event on Managing International Trade and Foreign Exchange

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