Start policy reforms, delink rupee & inflation

In the parlance of global investors and analysts, the Indian rupee is one of the world’s high-beta currencies. In plain language, it implies the rupee has high volatility and adverse risk-return characteristics. One implication of this feature is that the probability of a fall in the rupee over the next year and beyond is perceived to be higher than a rise. This perception gets accentuated at times of volatility through a positive feedback process.

The high beta characteristic of the rupee results in both foreign and domestic investors requiring a risk premium for investing in rupee assets. Other things being equal, this means a higher interest rate in India.

Although the long-term average annual depreciation of the rupee vis-a-vis the US dollar in the period since its becoming market-determined in March 1992 was lower compared to what was the case before, periodic bouts of sharp volatility have been a feature of the domestic forex market in India ever since. The last such was in August 2013, caused by frailties of slowing growth, rising inflation and a widening current account deficit that were exacerbated by prospects of a monetary policy reversal by the US Federal Reserve at that time.

The improvement in external sector fundamentals and the relative stability of forex markets since then resemble those of similar periods in the past which were, however, eventually punctured by bursts of volatility and sharp adjustments of the nominal and real exchange rates of the rupee.

In the past, both the government and the Reserve Bank would routinely claim after a fall in the rupee’s exchange rate that there would be little or no adverse implication for growth, inflation and budgetary position. But the facts turned out otherwise, specially in inflation.

A poignant illustration on this is given by the ballooning of the government’s liability in the decades after it got $470 million in early 1989 from Union Carbide for damages caused in the Bhopal disaster a little over four years earlier. This amount was sold to the RBI and, by court order, the rupee proceeds were invested in a special long-term government bond carrying 12 per cent interest, with a proviso that both the principal amount and the interest would be protected against any fall in the rupee’s exchange rate.

Thus, in effect, the government took upon itself the liability of a long-term US dollar bond but carrying a rupee rate of interest. The fiscal implications of this arrangement, due to the fall in the rupee exchange rate (that was about `15.70 to the dollar in early 1989) over the next 20 years or so when compensation was paid to the disaster victims, were enormous. The aggregate compensation paid by the government in that period amid the rise of the dollar by about 225 per cent against the rupee, was several multiples of the initial rupee proceeds.

The main reason for the fall in the rupee’s exchange rate over time, including in recent years, was higher inflation in India in contrast to its major trading partners. Viewed from that perspective, a vicious cycle of inflation-depreciation-inflation is still discernible in India, albeit in a longer timeframe than in the past. To address the structural reasons underlying this aspect, it is imperative to implement an inflation-targeting monetary policy framework as soon as possible.

The primacy of inflation management in setting the external value of the rupee could be understood in the light of the fact of lower average annual depreciation of the rupee in the post-reform era being largely the result of a better inflation performance in that period. RBI governor Raghuram Rajan’s comments in recent months to the effect that low inflation is a prerequisite for a stable rupee is a belated but very important recognition of an economic reality. Anchoring inflation expectations through a credible and consistent monetary policy framework will also cushion to some extent the risks to external flows from further monetary tightening in the United States.

Better structural stability in the domestic forex market will create conditions for the removal/relaxation of the slew of archaic capital controls that now drive a wedge between residents and non-residents on their access to it. These controls engender distortions in pricing of forex products, specially derivatives. And they provide the raison d’etre for the offshore non-deliverable forward (NDF) market.

The rising trade volumes in offshore NDF markets in places like Singapore and Dubai, as well as the growing role of those markets in the discovery of the exchange rate of the rupee are legitimate concerns. Intervention in the offshore forex market, though not impossible, is fraught with legal and operational hurdles. India does not have the advantages which China has in this regard in the form of its Hong Kong SAR. But India can learn from the Chinese experience in promoting the use of the rupee in trade and investment transactions with non-residents, that can be a stabilising force for the forex market. The recent listing of rupee bonds and rupee-based fixed income ETF in London are encouraging signs in this regard. All in all, it is time for expeditious monetary policy and forex market reforms.

The writer is a finance and risk management specialist, and a former central banker (The Billion Press)