In two recent speeches in the South, Reserve Bank of India (RBI) Governor Raghuram Rajan spoke about its exchange rate policy. In the speech Rajan delivered in Kochi, he argued that "until we bring inflation down… there will be a certain amount of depreciation (of the rupee), which is necessary to ensure that we don't become uncompetitive… Our focus is on bringing down inflation". However, "if you look at the real effective exchange rate, it is flat" (The Times of India, February 15). On the very next day, in Thiruvananthapuram, his emphasis was different - that unlike China, Japan or Korea, the RBI does not believe in an undervalued rupee to push growth up as this leads to problems in other areas and "was not a feasible or desirable strategy for growth". He firmly believed in the "RBI's philosophy of not focusing on the level of exchange rate… but trying instead to minimise… extreme volatility". (Does there appear to be some discord between his statements in Kochi and Thiruvanantha-puram?) Rajan went on to advise the audience, which consisted of those engaged in the micro, small and medium enterprises (MSME) sector, to focus on "cost effectiveness, innovations and ideas" (The Indian Express, February 16). I recall that his predecessor had also advised businesses to improve productivity to cope with an appreciating rupee.
The speeches raised the following queries in my mind:
1) Is inflation being brought down to make the rupee competitive, or is an overvalued rupee being used to pull inflation down?
2) Regarding the "flat" real effective exchange rate (REER), data on the RBI's website suggests something else: In August 2013, the six-currency index was at 108; in January 2016 it was at 124 (the broader 36-currency index also shows a similar trend). In other words, the REER has hardly been flat.
3) No matter how desirable improvement in productivity, innovation etc is, it is neither easy nor quick to achieve.
On the last point, the governor's year-end communication to RBI professionals evidences the difficulties. Rajan believes the RBI needs to transform itself from a "traditional, unimaginative organisation" to a "dynamic, intelligent one". His frustration in achieving the transformation is obvious when he says that "our regulations are not always very clear, our staff sometimes is neither well-informed of our own regulations nor willing to help the customer, our responses are occasionally extraordinarily slow and bureaucratic" (The Economic Times, January 12). If it is so difficult to change the culture and quality of work in an organisation consisting of some of the most highly educated and intelligent professionals, how realistic is it to expect MSMEs to increase their productivity and innovate?
The domestic industry's lack of competitiveness in the global markets and its inability to compete with imports in the domestic markets, thus adding to the non-performing assets of banks, is not the only effect of an overvalued exchange rate. A couple of other effects: A few years ago, I had studied hundreds of transactions between banks and their mostly MSME clients, involving complex, structured derivatives. Most of these transactions were dated between mid-2007 and mid-2008, a time during which the rupee appreciated to Rs 39 a dollar and exporters were incurring losses. In those circumstances, it was not too difficult for banks to persuade MSMEs to enter into complex, structured products, which were supposed to make them money and help mitigate losses on the exchange rate. The end result, however, was quite different, as exporters incurred huge losses on the derivatives. I have often wondered whether the mis-selling would have been equally
easy, had the exchange rate been more reasonable.
Again, a persistently overvalued currency encourages "carry trades" by way of unhedged long-term foreign currency loans, because the change in the exchange rate is less than the interest/inflation differential between the borrowed currency and the rupee. The RBI's exhortations to hedge would be helped if the economics of unhedged exposures are made unattractive through a suitable exchange rate policy that depreciates the rupee to the extent of inflation differential.
If the RBI is not focusing on the level of the exchange rate, as Rajan said, then who is determining it? In my view, it is the foreign portfolio investor. When there are net inflows, the rate appreciates; when there are net outflows - as there have been over the last eight months or so -the rupee falls. Is it wise to leave the exchange rate to the mercy of a score or so foreign fund managers? Instead of exporting goods and services, we seem to have exported the level of the exchange rate!
The author is chairman, A V Rajwade & Co Pvt Ltd; avrajwadegmail.com