The ongoing slowdown in the Indian economy and the widening of the current account deficit have brought exchange rate management by the Reserve Bank of India (RBI) back in focus. Even though the RBI has been intervening in the market, which has pushed foreign exchange reserves to record highs, the 36-currency export-based real effective exchange rate index in September was at 119, showing significant overvaluation. It is being argued that India is not able to take full advantage of recovering global trade because of rupee overvaluation.
Exchange rate management has become difficult for an emerging-market country like India. The latest World Economic Outlook of the International Monetary Fund (IMF), released on Tuesday, has mapped the volatility in capital flows to emerging markets. This, to a large extent, shows how difficult it has been for central banks to manage currency markets in recent times.
The roller-coaster ride started in the middle of 2013 when the US Federal Reserve hinted that it would start reducing the quantum of asset purchase sooner than expected. Capital flowed out of emerging markets and India had a near currency crisis. In 2015, concerns about devaluation of the renminbi affected market sentiment, and between the third quarter of 2015 and the first quarter of 2016, international investors sold stocks and bonds worth $52 billion in emerging markets. Thankfully, by then India had learnt its lessons and managed to remain largely unaffected at the macro level. Conditions turned more favourable in 2017; international investors have bought stocks and bonds worth over $200 billion in emerging markets, which is more than double the total for 2015-16. India has received foreign portfolio investment worth over $26 billion in the current year so far, compared with a net outflow of about $3.5 billion in 2016.
According to the IMF, capital flows are expected to recover at a moderate pace. This continued recovery would mean that in order to protect India’s competitiveness, the RBI will have to be prepared for more intervention in the currency market. Since capital flows are fairly volatile, non-intervention can affect economic activity and could be a potential source of risk to financial stability. One of the reasons behind the rupee crisis of 2013 was the lack of adequate market intervention in the preceding years, which resulted in a higher current account deficit.
As things stand today, the direction and quantum of capital flows could change rapidly if financial conditions begin to tighten in global markets due to a faster-than-expected rise in interest rates in the US, or any other unknown risk. In a recent paper, Real Exchange Rate Policies For Economic Development, which comprehensively reviewed the role of exchange rate policy in development, economists Martin Guzman, Jose Antonio Ocampo and Joseph E. Stiglitz noted: “...the major problem is when capital account booms are ‘absorbed’ by growing current account deficits, thus generating a deterioration of external balance sheets. Large current account deficits are a major source of financial risks when external financial conditions deteriorate.” It is also important to insulate domestic businesses from excessive volatility of capital flows and exchange rate. Excessive exchange rate volatility could affect investment and growth possibilities in tradable sectors.
So, what can India do in the given circumstances? The RBI and the government can work on at least two levels. First, the central bank should continue to intervene in the market to protect the competitiveness of the rupee. Intervention in the currency market has fiscal costs, which the government will need to bear, as the cost of non-intervention would be much higher for the economy.
Second, as this newspaper has argued before, now that India has adequate reserves, the government and the RBI should review the composition of foreign flows. India needs higher investment, but it can certainly decide the kind of foreign capital it wants. Equity investment is more stable compared to debt which sometimes flows in only because of interest rate arbitrage. India’s total external debt is at about 20% of the gross domestic product and a significant part of it is commercial borrowings. The possibility of currency appreciation would encourage businesses to borrow more from the overseas market, which will put further pressure on the rupee to appreciate.
However, at the international level, sustained intervention by too many countries could reduce the benefit and increase the cost. The global financial system would work better if the rules of engagement were more transparent. It should be clear to policymakers and multilateral institutions as to who is creating imbalances and which country is forced to protect itself. Policymakers should also coordinate and work towards reducing the potential risks caused by volatility in capital flows to emerging markets.
What can India do to protect its external competitiveness? Tell us at views@livemint.com