THE REPORT says that it is not possible and advisable to resist the long-run real appreciation of the rupee through persistent nominal exchange rate intervention. The best antidote to pressures for the exchange rate to rise is to ‘increase the flexibility of the economy to adapt to it and for firms to hedge the risk’.

 

It rightly says ‘sometimes adaptation is best achieved when firms realise they have no alternative’. For instance, exporting firms will have an incentive to achieve productivity gains by boosting their efficiency (we have seen this happen in some of our large manufacturing / service-providing units). These adjustments are much more likely to take place in an environment where manufacturers anticipate exchange rate appreciation and prepare for it. If manufacturers believe that the central bank (or fiscal authorities) will protect them from appreciation or that the government will offer sops to deal with the effects of appreciation, they will have no incentive to prepare for it in advance. (This of course is true of the Indian scenario to a great extent). When the inevitable, viz, exchange rate appreciation occurs, they are caught off guard.

 

Of course, the small and medium-sized units cannot adapt as easily. The medium-term answer is to help them do so, by favouring them with more flexible labour laws, better finance and managerial support services. (Flexible labour laws take their own time to arrive in India, although the other two are not that difficult for the SME sector to access, now). The Report firmly states that the macroeconomic framework should not be allowed to be held hostage by a small segment of the export sector, viz, the SME segment.

 

It points out that if the appreciation pressure is strong, intervention may just bottle up the volatility, only to unleash it when intervention stops. (We have been witnessing this in India particularly over the past year, post-RBI intervention). It bluntly says that tried and tested methods of exchange intervention cannot help preserve India’s competitiveness in today’s more open economy.

 

It does not believe in what the Committee on Fuller Capital Account Convertibility had recommended – that the real exchange rate should be maintained within a band. A more predictable and transparent policy framework can in fact generate more room for policymakers to respond to large shocks because the market would better understand the objectives of monetary policy. The way forward is to reorient the monetary policy towards focusing on price stability, which is defined as low and stable inflation. An exchange rate objective would limit policy options for domestic macroeconomic management and is not compatible with an increasingly open capital account. It justifies this statement by citing the Chinese example, which is discussed in the following paragraph. (Even finance finister, Chidambaram wondered not long ago how China was able to keep inflation under control in spite of registering a double-digit growth. Some of the answers to the question, indirect though, are to be found in the Report under ‘Lesson from China’).

 

In China, financial repression has kept the costs of sterilised intervention low by inducing state-owned banks to absorb large quantities of sterilization bonds at low interest rates. Not only has this ‘financial repression’ kept the price of capital cheap in the form of low interest rates, but energy and land have also been subsidized to encourage more investment. As a consequence, more than half of nominal GDP growth in recent years (almost two-thirds of growth in some years) has been accounted for by investment growth, with consumption growth accounting for a significantly smaller fraction. This has had serious environmental consequences and greatly limited employment growth. To keep the price of capital cheap for firms, China has capped the deposit rates. This has led to negative real rates of return for Chinese households, which save nearly one quarter of their disposable income and put most of it into bank deposits. Over the last year, the negative real interest rates have led to some money flowing out of bank deposits and into the stock market, ‘creating a huge bubble that is likely to end very messily’. But the increasingly open capital account has constrained the central bank’s ability to aggressively raise policy interest rates to control credit expansion and investment growth. If it tried to do so, even more capital would flow into the economy to take advantage of the higher interest rates, especially since interest rates in the US have been falling due to recent actions by the Federal Reserve. This would flood the economy with more money and complicate domestic macroeconomic management even more.