Stop-start in currency volatility: Markets deliver consistent daily shifts

There was an age when the government controlled petroleum-product prices, and those prices were not updated regularly. World prices would go up and the Indian prices would not. The gap would become larger, the economic distortions would get worse, and the pressure would build up. And then, suddenly, prices would change by a lot. These big price changes were shocks to the economy. The policy community learned from those experiences: It is much better to dribble out the news as a large number of small price changes that happen every day. Some days, the price of petrol should go up, on other days it should go down, reflecting fluctuations of the world price. The price of petrol should not be fixed. 

So it is with the exchange rate. It is possible to hold the exchange rate fixed for some time. But a gap opens up between the free-market price and the government-controlled price. This gap induces economic distortions and, in time, policymakers get the message. And then we get large moves of the exchange rate, which are even more disruptive than the flow of daily fluctuations of a free-market exchange rate. 

Let us dive into the mind of the firm. Every firm faces numerous fluctuating prices. The price of steel fluctuates, the price of natural gas fluctuates, the price of lithium-ion batteries fluctuates, the price of central processing units fluctuates, and the yen-rupee exchange rate fluctuates (even if the dollar-rupee is a government-controlled price). To be in business is to look at this landscape and figure out how to make money in this ever changing world. 

Weak firms want an easy life. They want the government to give them a fixed environment where prices of steel, cement, petrol, dollar-rupee, etc. are locked in. It is argued that if the government does all this, the firms will learn to produce and export. From the viewpoint of Indian economic growth, there is no point in having such weak firms. The essence of economic development lies in the emergence of capable firms. 

Isn’t exporting the ultimate path to economic success? Policymakers can get export growth for some time through subsidies, whether a production-linked incentive or a falsified exchange rate. But these “fake exports” are missing the point. Exporting is not the end: Capable firms with high productivity are the end. Exporting prowess is the thermometer where we get to read the capabilities of the firms, when firms fight fair and square to achieve exports, they achieve productivity. Fake exports should be seen as painting the tape, as falsifying the meaning of a statistical measure. 

How does a firm learn to play in the complex world? It must have deep sources of competitive advantage. Price fluctuations knock out weak firms, which is a good thing for society. High-productivity firms are those that build organisational capability that copes with price fluctuations. Organisational capability never emerges quickly: It takes many years of purposive effort to get to high institutional capability. 

This shows us the connection between government-managed prices and economic development. When the government fixes the price of steel, it enfeebles the firms, which do not learn how to build organisational capability. Weak firms that ought to have been destroyed by price fluctuations linger on in the landscape, occupying resources that should be freed up in creative destruction. 

Part of the story in high-productivity firms lies in their business model and organisational design, through which good firms are resilient to price fluctuations. A second part of the story lies outside: In the emergence of liquid and efficient derivatives markets. In a market economy, prices fluctuate all the time, and firms buy short-term protection using derivatives, which creates liquidity and capability in the financial system surrounding the derivatives industry. When a government shuts off price fluctuations (and, worse, when the government restricts derivatives trading), these capabilities are lost. 

Spells of a managed exchange rate, followed by large changes, are thus the worst of all worlds. Those lull the firms into complacence: They take on more exchange-rate risks, and fail to develop organisational capability for the real world where exchange rates fluctuate. And then, inevitably, it always happens that the government is no longer able to control the price, and a big price change comes along. The firms — even the good firms! — lack the strength to cope with price fluctuations and get hurt. The derivatives markets are feeble, they do not have GDP-sized numbers swirling in them, and are not able to supply protection on the scale required. You can’t buy flood insurance once the waters start rising: It takes decades for a capable insurance industry to develop. The firms respond in the political economy, lobbying the government to block price fluctuations, which reinforces the worst elements of the public-policy landscape. 

This reasoning shows us how government management of prices, in general, and the exchange rate, in particular, runs afoul of the journey of economic growth. It is always tempting to achieve political objectives, or to support firms in genuine distress, by preventing the operations of markets. Practical people in firms, who tend to emphasise execution issues, often support ideas that harm Indian firms on a strategic scale. 

One great milestone in the Indian journey was when the Reserve Bank of India (RBI) graduated from being “a temporary measure” of the British, to having a mandate of the inflation target of 4 per cent. This part is now widely understood in the policy discourse: The single great contribution that the RBI can make for the Indian growth journey is to reliably deliver low and stable inflation, to rule out the possibility of an inflation crisis. Sometimes, the impossible trinity offers the temptation of a situation where exchange-rate objectives and inflation objectives can coincide. Policymakers must resist this temptation because it sets us up for the stop-start of periods of currency management, which harm economic growth.

The writer is a researcher at XKDR Forum