Intervention Without A Purpose

Alan Walters, who was knighted for his role as economic adviser to Margaret Thatcher, recounts his experience at the time of the Bank of England's intervention on currency markets with the following cautionary tale. Whenever the Bank was asked why they were intervening in support of the exchange rate, the answer would invariably be that they were conducting "a smoothing out operation". When questioned further, they would point out that they had only used up a few million dollars to support the pound.

At the end of the week when the reserves would be officially reported to the Prime Minister's Office, it was invariably found that the few million dollars had actually mounted to a few hundred million dollars. On further analysis it would be discovered that the hundred millions were just the tip of the proverbial iceberg. In fact, the central bank had spent much more even than this in defending the currency through swap arrangements with other central banks and intervention in the forward foreign exchange markets.

Thus the reserves had been encumbered with future liabilities, which would be realised when the swaps were unwound, and the period for settling forwards came due. All in all, it turned out that the intervention had not cost just a few million dollars but a few billion. In fooling the public the central bank had fooled the government, and much to her chagrin it had also fooled the Prime Minister who, under Alan Walters's tutelage, had become a strong non-interventionist.

In India, the language and reaction to intervention is slightly different; we do not refer to " smoothing out operations" but to "alleviating temporary mismatches", as if the underlying demand and supply schedules of foreign currencies were such that all these mismatches would be reversed. The reactions are also quite the opposite to the Thatcher-Walters line. At first everyone waits with bated breath to see what the authorities are going to say. Then, if the finance minister declares the problem to be temporary, no one believes him. Like Mandy Rice Davis everyone concludes: "He would say that wouldn't he?" The Reserve Bank counters by making a few irrelevant statements confirming that they have never had a target exchange rate and that they are only interested in restoring orderly markets.

Journalists, whose favourite sport is the needling of men in power, promptly report in lurid headlines that the rupee has collapsed even though the exchange rate may have moved less than 5 per cent. But this crescendo of comment guarantees a response from a nervous Reserve Bank. Men in power cannot show their edginess, so they transfer their psychosis of fear to the markets. They pretend that volatility is bad for markets when what it is actually bad for is their own nerves.

One of the meanings of "psychosis" is a derangement of the mind through hallucinations; and the haunting hallucination that leads to disorderly central bank reaction is the belief that they have lost control of the markets. Extraordinarily, whenever the exchange rate happens not to move for some reason or other they believe that they are fully in control and if it moves they feel they have lost control. Traders in foreign exchange fully realise this psychology of the central bank, and therefore at all times, they test the bank's resolve. Unfortunately, central banks cannot resist this macho game.

Ila Patnaik, in her admirable analysis "Does the RBI know what it wants?" (Business Standard, August 14) finds no justification for central bank intervention unless it is the cornerstone of the bank's exchange rate and monetary policy to prevent speculation. She finds that ridiculous. But central banks positively revel in this speculation-counter-speculation game, just as much as Sachin Tendulkar revels in bashing a cricket ball for a six.

Central bank passion for defending the domestic currency suits the speculator. It is now well known that George Soros made his billion by forcing sterling out of the European fixed exchange rate system (ERM). Soros knew full well that the British would defend the pound for all it was worth, and that the Germans would not help the British at all. His information was sure because he had carefully studied the policy statements made by both sets of authorities and had had it confirmed from private analysts.

The denouement came on Wednesday, September 16, 1992, popularly known either as Black Wednesday or White Wednesday depending on whether you believe in fixed or floating exchange rates. Referring to intervention through interest rate rise and the purchase of sterling by the bank, the Chancellor of Exchequer, Norman Lamont, informed Prime Minister John Major: "It has not worked. They (the speculators) are still selling."

It would have been disastrous if it had worked. For, although the sellers won the day, the government's defeat won the war. For, the British were forced to abandon the fixed exchange rate system and ever since that time the British economy has performed spectacularly well while the Europeans have continued to stagnate.

And that episode should be at the heart of the debate about India's exchange rate policy. In the seven years that have subsequently passed, the pound has fallen from an unstable exchange rate of $1.93 to a freely floating exchange rate of $1.50, but both growth rates and employment rates have improved substantially while Europe continues to have 10 per cent unemployment rate which is euphemistically described as "structural".

In India, no economist worth his salt bothers about unemployment. As with all those miasmic Indian statistics, no one has a clue about what our unemployment levels are. Ordinary economics teaches us that a fall in the exchange rate should reduce the real wage and consequently improve employment.

I readily concede that that does not always happen, but there is certainly no economic ground which would justify the ridiculous game that the Reserve Bank is now playing. For the simple fact is that there is no way of knowing what the exchange rate should be. In a market-determined exchange rate there will be much mis-pricing and learning by trial and error, but there is no other way. It is, therefore, a tragic error that the Reserve Bank prevents markets from embarking on this voyage of discovery by their bias for the status quo.

For let it be clearly understood that a rupee which has been defended by the raising of interest rates, forcing corporates to bring back their foreign balances and penalising exporters by reducing incentives on their exchange earnings, is in no way market determined. It does not reflect the free market value of the rupee. The Reserve Bank has done a great disservice to the agenda for reforms whatever the Prime Minster may say from the ramparts of Red Fort.

In their defence it will be argued that the supposedly brilliant management conducted by our economic team prevented us from being affected by the East Asian contagion. But that is a purposeless objective. Burma has been shielded from all contagion of any kind for years but their path is not one that India should emulate. The purpose of economics should be growth and employment and neither is served by the Reserve Bank's exchange rate policies.