Currency intervention and MSS

WORLD MONEY

I am not quite sure what is puzzling me more: criticism of the exchange rate policy and the accumulation of reserves; or the Reserve Bank of India's (RBI's) preference for the so-called market stabilisation scheme (MSS) over an increase in the cash reserve ratio (CRR).

One example of the former is the article "Feeding an elephant" by Ila Patnaik (Dated, February 18). It accused the RBI of "manipulating the currency market", of playing a "game" that is "non-transparent" and imposing "massive costs" on the "people of India".

The central bank's alleged crime has been, first, intervening in the exchange market to mitigate the rupee's appreciation arising from excess supply of dollars in the market. Second, sterilising the consequential surplus liquidity in the rupee market, which imposes costs.

Patnaik further contends that the rupee's appreciation against the dollar has had "no discernible effect in slowing down exports growth".

It will be worth looking at some of these points individually:

• If managing the exchange rate is a crime, then the RBI is in the company of other central banks, including the Bank of Japan and Bank of China, which have committed the same crimes on a bigger scale.

Horst Kohler, the International Monetary Fund's managing director, recently said that the policy of the Japanese authorities "is pragmatic and helps stabilise the financial system and battle deflation".

Apart from the cost of sterilised intervention (that is, the difference in yields between what the foreign exchange reserves earn and the foregone yield on government securities), one also needs to look at the cost of non-intervention.

If, in that case, the exchange rate goes to, say, Rs 41, the financial costs on the central bank balance sheet would be in excess of $10 billion (Rs 45,000 crore) by way of translation losses on the foreign currency assets "" this is, say, 2 per cent of GDP "" and would bankrupt the central bank. Clearly, such translation losses, if incurred, would also need to be borne by the "people of India".

But these are merely the direct financial costs of rupee appreciation.

The economic costs of rupee appreciation could, of course, be far bigger with the loss of competitiveness of industry in both domestic and foreign markets.

A rise in currency is deflationary and would surely inhibit investment, growth and employment "" no wonder Japan or China do not consider managing the exchange rate as a crime against the people of their respective countries.

It is true that the rupee's appreciation against the dollar has not affected export growth so far. (Our export growth is much less than that of China, Brazil, South Korea and so on).

But this appreciation is illusory "" what is more relevant is that, in real effective terms, the rupee has hardly appreciated. No wonder export growth remains on track. Even then, the merchandise trade deficit has doubled and is running at 3.5 per cent of GDP.

But let me turn to my second puzzle. Since dollar purchasing adds to the liquidity in the rupee market, the RBI has been mopping up the excess through the sale of government securities.

As a result, the stocks of government securities held have dropped sharply. (A doubt: would the RBI be equally prompt in buying securities when the situation is converse? Remember 1996?)

This depletion in the ammunition for open market operations is sought to be made good by MSS. MSS envisages the issue of government paper at market rates, the proceeds remaining as a credit balance of the Government of India in the RBI's books.

The reason for preferring MSS over a higher CRR seems to be that "the cost is borne by the banking sector if CRR balances are not remunerated" (Working Group Report). But should the RBI be concerned over bank earnings on excess liquidity that would not be there but for the intervention, that in a way is a bonus?

Moreover, the operating profit of the scheduled commercial banks last year was Rs 40,000 crore, on capital and reserves of a little less than a hundred thousand crore "" or a return on equity in excess of 40 per cent!

And this, when the riskless rate of return was just about 6 per cent. By almost any yardstick, the return does seem ample enough to bear the costs of an increase in the CRR by, say, 4 per cent (equal to the current MSS tranche of Rs 60,000 crore).

It could be argued that the last year's results were inflated by profit on sale of securities. True, but even after adjusting for this, the return on equity at the operating level was of the order of 27 per cent, that is, more than four times the riskless rate.

But this apart, on first principles, I remain convinced that it is dangerous to allow capital inflows to determine the exchange rate to the detriment of the real economy.

As Robert Wade of the London School of Economics wrote to the Financial Times recently, "the story of our time could be written partly as a story of how money capital has come to dominate fixed capital, accompanied by more frequent financial crises, higher consumption volatility and rising income inequality within and between nations".

Email: avrco@vsnl.com