Suman Bery: The resurgence of the dollar

Is the present weakness of the rupee likely to last.

While containing inflationary expectations is clearly his immediate priority, the incoming Reserve Bank Governor Dr Subbarao also has some difficult calls ahead on the exchange rate of the rupee. At the time of writing, the dollar has been strengthening globally against all other major currencies, while the rupee has continued to weaken. Is this likely to continue? Should it be welcomed?

He will not be short of advice. He has already signalled that he will seriously consider the recent reports of the Mistry and Rajan committees (dismissed by his predecessor, Dr Y V Reddy, as “unsigned” and “draft”). Each of these expresses a clear view on the medium-term framework for managing the exchange rate, with a preference for much greater exchange rate flexibility.

Recent newspaper columns by Subir Gokarn (in this paper), Ila Patnaik (in the Indian Express) and Ajay Shah (in the Asian Wall Street Journal) have also addressed this issue. While Gokarn is more concerned with improving the clarity with which the RBI communicates on the exchange rate regime, the latter two both recommend sale of reserves (and its correlate, an appreciation of the rupee) as an immediate anti-inflationary intervention.

By contrast, Shankar Acharya, in his Business Standard column of September 11 (“A few good men”), reiterates his strong disagreement with this view. He compliments the outgoing Governor for choosing to contain the real appreciation of the rupee (his phrase) through vigorous sterilisation and liquidity operations (and some liberalisation of capital outflows). On this score, I am certain that Surjit Bhalla, another distinguished contributor to these pages, would agree. Indeed, I imagine both would perhaps consider engineering a deliberate nominal appreciation of the rupee to be even less responsible today than in 2007, given our yawning trade deficit and slowing industrial production.

For myself, going back to my joint work with Deepak Lal in 2003 and extending to my more recent participation in the Rajan committee I have been in favour of greater two-way flexibility in the rupee, more moderate accumulation of reserves and less sterilisation. Keynes is famously reported to have remarked, apparently also in the course of a debate on monetary policy, “When the facts change, I change my mind. What do you do, sir?”

The facts certainly have changed! When Lal, Pant and I first published our paper on this issue in 2003,* we had no way of knowing that we were on the eve of the biggest global boom in thirty years. In that bygone era Dr Jalan was the RBI Governor, India’s foreign exchange reserves were around $70 billion, India’s balance of payments was in current account surplus and international prices of commodities and manufactures were both under control. Since then we have experienced a complete global cycle, which, as it happens, coincided with Dr Reddy’s term as RBI Governor.

Today, the OECD economies are slowing more or less synchronously, major western financial institutions are under siege, and, with the possible exception of Japan, headline inflation remains a major policy concern. Here in India, as already noted, the balance of payments and fiscal policy are both under strain at an extremely delicate political moment. While history seldom repeats itself, it is difficult not to be reminded of the 1990-91 crisis, as also of the important and courageous role that an earlier ex-Finance Secretary, S Venkitaramanan, played as RBI Governor in that era, at a time of governmental transition.

Where exchange rate management is concerned, the new Governor will need to balance a broad range of considerations: tactical and strategic, short- and medium-term, and international and domestic. Furthermore, his management of the exchange rate needs to be consistent with domestic liquidity and monetary management, and supportive of a broader agenda of financial sector reform. Finally, as with any new central bank head, the markets will undoubtedly wish to test his mettle and resolve. This will require him to be reassuring but not entirely predictable.

In thinking about these issues at the present economic juncture, I have been influenced by a recent article by Raghuram Rajan in the Financial Times.** There he argues (for emerging markets as a whole) that the present global moment represents a seismic shift in the specialisation patterns of the developed and emerging economies.

Over the cycle now ended, the former group (largely the US and the UK, Germany and Japan less so) chose to specialise in the production of non-tradable goods (particularly housing, also healthcare and certain categories of government services). This pattern was financed by the issue of liabilities against themselves. The emerging economies on the other hand chose to specialise in the production of tradables, and to run current account surpluses.

In the case of East Asia (China, Korea, ASEAN) this was primarily in production of manufactures, while in the case of India it was both manufactures and services. India’s aggregate demand has been more evenly balanced between domestic and foreign sources than other Asian countries (particularly China), which perhaps is why our current account has moved into deficit more quickly.

This pattern of specialisation is now in the process of reversing itself as part of the righting of the so-called global imbalances. If the first phase required (and was reinforced by) a real appreciation of developed country currencies (against developed), rebalancing will require the opposite. I agree with Rajan that this is best done regionally, although I am dubious that we have the institutions to broker such agreements. The alternative which is what we see today is real appreciation in most emerging markets through the much costlier route of differential inflation. Given the aversion to inflation in both India and China, I cannot but imagine that this phase will soon end.

To conclude, I believe that the respite that the new Governor has earned on the exchange rate is likely to be temporary. Pressures to appreciate the exchange rate are likely to return. Accordingly, this is the time to think carefully on how to manage the next episode so that the wave of capital can indeed be directed to what Rajan has dubbed “profitable, productive growth”.

*Deepak Lal, Suman Bery, and Devendra Pant. 2003. “The Real Exchange Rate, Fiscal Deficits, and Capital Flows: India, 1981-2000,” Economic and Political Weekly 38(47):4965-76.
**“Emerging markets must shift their focus inwards,” Financial Times, August 19, 2008.

The author is Director-General, NCAER. The views expressed are personal.