Use Reer Benchmark For Intervention

RBI should have a MERB of +/- of 5% and intervene when REER is out side the band

The neutral real effective exchange rate (REER)-- the base period should be announced

REER Monitoring Band should be declared

The REER should be published on a weekly basis

Our Banking Bureau MUMBAI

Changes in the neutral REER should be made public

The Tarapore committee has recommended that the Reserve Bank of India (RBI) should have a monitoring exchange rate band (MERB) of plus or minus five per cent around the neutral real effective exchange rate (REER).

It has advised the central bank to generally intervene as and when the REER is outside the band.

 

However, the RBI could use its own discretion to intervene even within the band to obviate speculative forces and unwarranted volatility.

The committee has expressed the view that a move towards capital account convertibility would logically ensure that the forward premia in the forex market reflect interest rate differentials between overseas and domestic markets.

It has also recommended that as part of exchange rate management greater attention should be focused on ensuring that the forward exchange markets reflect interest rate differentials.

The committee has also suggested that the RBI should undertake a periodic review of the neutral REER which could be changed as warranted by fundamentals.

It has stressed that the credibility of the exchange rate policy would be vital in the context of capital account convertibility and said that a transparent exchange rate policy is of utmost importance.

In this regard it has said that the neutral REER i.e., the base period should be announced, the REER Monitoring Band should be declared, the REER should be published on a weekly basis with the same time lag as the publication of the reserves and changes in the neutral REER should be made public. The exchange rate regime proposed by the committee is expected to provide greater transparency. This would greatly enhance the efficacy capital account convertibility of the exchange rate policy by encouraging orderly market behaviour.

A Monitoring Band, built around the neutral REER could be expected to provide an environment to the market participants for anchoring their expectations. Also, an element of discretion in intervention by the RBI would be necessary.

Finally, the central bank is expected to use its best judgement in the evolving situation and operate its exchange rate policy as warranted by these circumstances. The policy pursued with respect to exchange rate management will change once capital account convertibility is ushered in. With large capital inflows, the exchange rate would appreciate in both nominal and real terms, which would hurt India's international competitiveness.

Hence, the policy will differ both in content and character compared to a situation where there is comparatively lower capital mobility. It has been pointed out that sterilization as an exclusive instrument for dealing with excess liquidity is not feasible and that sterilization along with monetary policy measures, relaxation of capital outflows and other measures can be effective.

Commenting on the government's borrowing programme it has suggested that, in 1997-98, the borrowing programme could be put through without recourse to the monetisation projected in the budget.

This would ensure that a sizeable portion of the large inflows can be sterilised quite effectively.

To the extent capital account convertibility integrates both the real as well as the financial sectors with the international economy, the impact of external impulses would be felt more strongly as a consequence of which macro-economic variables, both real and nominal, will have to respond expeditiously.

This also engenders larger borrowing abroad by domestic entities which further appreciates the currency, bringing in its wake more borrowing.

A debt-led expansion in economic activity may emerge, but there is always a possibility that either on account of a loss of credibility or when the real appreciation becomes obviously unsustainable or as a result of any unforeseen event, a reversal of the process could take place leading to reversal in exchange market sentiments causing a sudden and uncontrollable spiral of depreciation of the currency.

The committee has pointed out that an excessively overvalued exchange rate may trigger capital flight resulting in a crisis and persistent overvaluation of the currency would militate against viability of the export sector. Hence it would be desirable to evolve a system under which any corrections of the real effective exchange rate which may be necessary are brought about smoothly to avoid any sudden volatility in the exchange market.