India refused to use exchange rate as an instrument of macroeconomic adjustment in 1950s
- An episode from the 1950s illustrates that a failure to use the exchange rate as an instrument of macroeconomic adjustment can be costly.
Fixed exchange rate – Rupee overvalued rupee in 1950s:
- With the exchange rate fixed at 4.76 rupees per dollar during the 1950s, the rupee was overvalued relative to foreign currencies.
- This made India’s goods expensive relative to foreign goods and resulted in the import bill consistently exceeding export revenues.
- The gap had to be covered by running down scarce foreign exchange reserves.
- By early 1958, the reserve almost ran out.
Yet, rupee not devalued – govt chose forex budgeting:
- Rather than devaluing the rupee to properly align the prices of domestic and foreign goods, the then government resorted to what is known as foreign exchange budgeting.
- Beginning with the second half of 1958, every six months the finance ministry began preparing a detailed budget of how the expected foreign exchange revenues over the following six months would be allocated across different ministries.
- That process multiplied the complexity and cost of investment licensing: No licence for investment in a project could now be given unless the finance ministry allocated foreign exchange necessary to buy foreign machinery and inputs.
Lead to import controls:
- With high inflation making Indian goods progressively more expensive relative to foreign goods, export revenues shrank and import demands expanded leading to progressive tightening of import controls.
Move to flexible exchange rate system:
- It took India another three decades to accept that the exchange rate was a key tool of macroeconomic adjustment.
- With reforms launched in 1991, it adopted a flexible exchange rate system, with the RBI intervening in the foreign exchange market only to smooth out short-term fluctuations.
- As a result, value of the rupee has changed from Rs 17.50 per dollar in 1990 to Rs 74 today.
Important for macroeconomic stability:
- This depreciation has been crucial for maintaining both overall macroeconomic stability and robust growth during these years.
Understanding the recent rupee depreciation
Opening up of capital account in 1990s meant money flew in and out of India easily:
- Post-1991, the opening up of our capital account was initially limited to foreign direct investment (FDI) and equity investment.
- But this changed in recent years with the government opening the door wider and wider to financial capital flows.
- These flows are far more liquid than FDI and equity investments and can enter and exit the country fast in response to changes in interest rates abroad.
Lot of investment into India after 2008 crisis:
- Following the 2008 global financial crisis, interest rates in the United States progressively fell, leading foreign investors to move more and more funds into Indian debt. (Basically, when the interest rates in the US are low, market investors take some risks to invest in slightly risky destinations like India. When interest rates in US are high, they find it safer to move their investment back to the US.)
- Since these funds helped keep the interest rate on the government debt low, the government found it attractive to progressively liberalise the cap on them.
Indians also borrowed from outside:
- In parallel, Indian corporates also sought and got progressively greater access to lower-interest external commercial borrowings (ECBs).
This prevented rupee from depreciating:
- Steady inflows of capital also kept the rupee from depreciating, which ensured high dollar returns to foreign investors and low rupee cost of servicing ECBs for Indian corporates.
Sustainable as long as interest rates are low in the US:
- As long as interest rates in the United States remained low, these capital inflows produced a happy outcome for the government, foreign investors investing in Indian debt and Indian corporates borrowing abroad.
But recently interest rates in the US started rising and money moved out:
- But an upward turn in the interest rates in the United States recently jolted this happy equilibrium.
- Not only did the availability of foreign financial capital suddenly dry up, several years of accumulated investment in Indian debt sought to exit.
- Foreign institutions that could recall loans given to Indian corporates did so as well.
- Some foreign investors in Indian equities also sought exit to earn the higher interest rates at home.
Resulted in rupee depreciation:
- These exits required the conversion of massive volumes of rupees into dollars over a short period.
- That put downward pressure on the value of the rupee.
This led to calls for RBI to intervene with its forex reserves:
- The only way that RBI could have maintained the original value of the rupee was by selling as many dollars from its reserves as demanded by exiting investors at the original exchange rate.
RBI’s decision not to do that was wise for two reasons:
- It actually prevented exit of more money:
- The depreciation discouraged exits by effectively increasing the cost of converting rupees into dollars.
- On the other hand, a stable rupee (through RBI intervention) would have led to much larger exits, heavily depleting RBI’s foreign exchange reserves.
- Led to shrinking of imports thus helping current account:
- With private actors instead of RBI supplying dollars to exiting investors, dollars available for imports shrank.
- That forced much needed adjustment in the current account.
Oil price impact not very significant:
- Much has been made of oil price hike in the current episode.
- No doubt, the price hike added to the difficulties of foreign exchange management.
- But it was no more than a sideshow.
- Even without oil price hike, the rupee depreciation would have been less only by a small margin.
Way forward – need to watch for how open we are to capital flows:
- The worst of this episode is perhaps behind us.
- We must not let repeat episode go to waste, and learn lessons.
- We must reassess the wisdom of opening the economy wider and wider to financial capital inflows.
- Using low-cost foreign financial capital may seem attractive but it has associated costs.
- Eventually, when the inflows reverse, which they inevitably do, the economy does pay for it and rather heavily.
GS Paper III: Indian Economy