A Do-It-Yourself Guide To Devaluation

The government seems to be moving towards some decision on the exchange rate; it may be worthwhile to lay out the basic issues simply and soberly at this stage. The question is: should Reserve Bank reduce the external value of the rupee below the present value of about 2.65 US cents? The question arises because the real effective exchange rate (i.e the exchange rate corrected for relative price changes in India and abroad) has risen by about 14 per cent since March 1993. That fact by itself would not be sufficient to clinch the case for devaluation. But export growth is unsatisfactory, and exporters are complaining of stiff competition abroad -- in other words, they are saying that other countries, notably China, are underbidding them. Competition may intensify further now that the currencies of Thailand and Indonesia have been devalued.

The first question to ask is: is devaluation the best policy in the circumstances? The answer is no. The best thing to do would be to abolish import licensing, and to reduce import duties to a level where exporters will no longer need to take advance licences and duty drawbacks. However, the present commerce minister and commerce secretary are prehistoric people. They did the most cosmetic reduction of the negative list possible in the last export-import policy. They are fighting tooth-and-nail in the World Trade Organisation to retain the negative list as long as possible. They are trying to gang up with the European Union, another primitive protectionist, to defeat US pressure to open up. Before Mr Chidambaram, the commerce ministry was a den of corruption and a bastion of protectionism; it is rapidly returning to that state. To think that the present minister and secretary will allow import liberalisation is unrealistic.

But devaluation is a better policy than liberalisation of capital exports. Before liberalisation, the business environment in India was so bad that big Indian businesses preferred to invest abroad. This is less so today, when the South-east Asian economies are losing their lustre. So the chances of a substantial outflow are poor, and liberalisation of outflows will probably have no perceptible effect. But capital invested abroad creates jobs abroad; if invested in the country, it creates jobs here. Instead of liberalising capital outflows, the government should be working to make India an attractive base for all investment, Indian and foreign.

Will devaluation work? Some economists think it will not. In their view, exports are limited by infrastructure bottlenecks. In my view, such bottlenecks are not absolute. Electricity shortage is perennial, but power supply has been rising year after year. Ports are congested, but some are more congested than others, and if exports are profitable, exporters will find ways to ship out their goods, such as sending goods by air, loading off-port and transhipment in better ports abroad. Other economists think that Indian exporters export cheap, substandard goods, and that the way to increase exports for them to improve quality and raise value added. Granted; but it remains true that our substandard exporters will make bigger profits and want to ship out more substandard goods for more foreign exchange if the rupee is devalued. In other words, export earnings would increase even further if the power sector is reformed, if port capacity is increased, if infrastructure management is improved. But even without these things, devaluation is likely to have a significant impact on exports.

The principal argument against devaluation is that it would require Reserve Bank to buy up dollars; that would release rupees into the economy and increase money supply, which is supposed to be inflationary. I happen to believe that the factors behind inflation in India are largely non-monetary -- that they are to be found in the large public sector deficit, in the poor productivity growth in the state sector, in the governments pushing up of agricultural prices. But I do recognise that monetary orthodoxy is no longer confined to Reserve Bank; many respectable economists have bought the monetarist dogma that prices are determined by money supply.

A monetarist who agrees with me on the need for devaluation is impaled on the horns of a dilemma: he likes devaluation but does not like the rise in money supply. Prem Shankar Jha, one such impaled soul, has a solution: Reserve Bank should buy no dollars, but its luminaries should make fierce speeches saying the rupee is overvalued. The market will then take fright and meekly climb down.

Maybe this is what Dr Y V Reddy was trying to do with his speech last week. It is the logical thing to do for Reserve Bank, which is madly monetarist. Working on the psychology of the market requires finesse and control; I doubt if Reserve Bank has either. The prime ministers revelations to The Economic Times on the band certainly did not help. A band is always a good idea, but a band would make Reserve Banks control of forward rates very tricky. RBI would have to become much less fussy about the foreign exchange market if it is to introduce a band. And a band is quite irrelevant to the engineering of a devaluation: after it is introduced, the rupee is as likely to appreciate as to depreciate.

Since I am not a monetarist, my prescription is quite the opposite to Mr Jhas. I think Reserve Bank should aim to gain the maximum reserves per paisa of devaluation. It should make strident statements saying that the exchange rate is determined by the market (nonsense though that is), that it has no intention of forcing down the rupee, that it believes in a strong and stable rupee, that a strong rupee imposes salutary discipline on exporters, etc; at the same time it should buy up big chunks in the foreign exchange market and make it run out of stocks, so that whenever the State Bank steps in on behalf of ONGC, the rupee will go down. Reserve Bank should aim to pull in at least $10 billion before the rupee reaches 2.5 cents. When the rupee reaches that figure, import duties should be reduced so as to keep import costs at the same level as before devaluation. Around that point Reserve Bank should use all its reserves if necessary to stabilise the rupee.

And what about the effects on money supply? The worst thing to do would be sterilisation -- i.e selling government bonds to mop up the extra liquidity. I have seen terrible cases of countries sterilising capital inflows and in the process, raising interest rates so much that foreign capital keeps flowing in, leading to inflation and the collapse of industry.

Reserve Bank should allow the increase in money supply to force down interest rates. It should stop regulating the bank deposit rates. Given the inefficiency of the government banks, lending rates can come down only if the deposit rates come down. And if inflation threatens, RBI should raise the cash reserve ratio. That is the solution to RBIs dilemma: it need no longer impale itself if it remembers this policy parameter called the cash reserve ratio.