January 13, 2005
Are we going back to control raj? RBI governor Y V Reddy has argued in favour of fresh restrictions on Foreign Institutional Investors and FDI flows. RBI wants such measures because it feels that more repressive controls are the only way through which it can continue to manipulate the currency market. But there’s a better way.
India’s aspirations of becoming a modern market economy are better served by letting market forces determine the exchange rate, and simultaneously moving towards capital account convertibility. What the Indian economy needs is not more government meddling in the exchange rate, but a system which is more resilient to higher currency volatility.
The RBI governor’s comments are reminiscent of Indian economic policy from the 1970s, with a enormous control machinery being tweaked in myriad ways by a government that was supposed to cater to the interests of citizens.
Such policies have been tried and rejected in every aspect of the Indian economy. They breed corruption, they give incentives to individuals and households to distort their activities so as to dodge the controls, they expand the black economy, and they hold back the growth of the Indian economy.
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RBI is unfortunately out of touch with contemporary ideas in Indian economic policy. The Indian government now allows prices to move. No longer is the price of steel or cement set by administrative measures. The rupee is also no longer set by official announcements.
India chose to have a ‘‘market determined’’ exchange rate in the early 1990s. However, the inability of the central bank to change its mindset meant that it continued to buy and sell heavily in the rupee-dollar market to manipulate prices. Over the last few years, as the size of the foreign exchange market has increased, it has become even more difficult for the RBI to fix the rate.
Today, it is the RBI’s frustration at its shrinking power to manipulate the rupee that makes it wish to reduce the size of the market. The increase in the size of reserves is not an outcome of inflows, it is the outcome of RBI buying dollars to manipulate the rupee dollar rate and keep it’s movements within a narrow band.
It has taken over ten years for India to obtain credibility in the eyes of global investors for both FII and FDI. Indeed, in many respects, India’s achievements on the equity market and FII investments into the equity market are now held up as a success story on a global scale.
Such credibility can be swiftly lost if India has a central bank that sets about reversing the reforms. It is all too easy for the global community to switch back to their traditional assumptions about India as being an outpost of control raj, not to be taken seriously as a destination for investment.
RBI wants to cling on to their control of the exchange rate, and this can only be achieved by bringing back controls on FII and FDI flows. Most modern market economies have evaluated the same choice, and done differently. Controls introduce enormous distortions— as we in India know too well. Hence, most countries have chosen to allow the currency to be determined on the market, and avoided capital controls. RBI’s thought process is strikingly out of touch with modern economic ideas. If India aspires to become a modern market economy, then we need a central bank that acts like the central bank of a modern market economy.
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