Sense in currency

The depreciation of the rupee seen in the last few days is good news on many counts. Under the NDA government, the manipulation of the rupee-dollar exchange rate by the Reserve Bank of India had created conditions for an inflow of hot money into the country. RBI’s “currency management” allowed the private sector to clearly see where the rupee was going to go next. Huge profits were made by foreign funds, NRIs and others, who could speculate on the foreign exchange market. It was the Indian tax-payer who ultimately paid for this currency policy. In the last few weeks, the greater volatility of the rupee has put an end to this bad phase.

India’s new-found success in exporting led to a current account surplus in 2001-02. Instead of letting the rupee-dollar rate adjust to this, the RBI zealously engaged in market manipulation. It bought dollars in order to prevent the rupee from appreciating against the dollar. What should have been a large, quick appreciation of the rupee was instead smeared over an 18-month period, during which speculators were able to accurately forecast what would happen next. So there was an influx of dollars into the country. Foreigners, NRIs, exporters and importers betted on rupee appreciation. RBI’s activities on the market led to a huge rise in foreign exchange reserves, far beyond the requirements and resulting in the country incurring huge costs in several ways. From the middle of March 2004, the RBI seems to have abandoned this stance. Many governments fumble in their handling of the currency in periods of difficulty. It is thought that the job of government is to “support” the stock market and the currency, and that this will improve the confidence of foreign investors. Instead, what generally works out is that the government holds an umbrella out to support exit by foreign investors at advantageous stock prices and advantageous exchange rates. The price of such “support” is always borne by domestic citizens, and foreign investors — who get to exit using high asset prices — are the beneficiaries.

A mature government in a market economy is one that allows prices to be discovered on the market, without market manipulation. It is good that the RBI stayed away from the market and did not step in to defend the rupee in the last few days. Higher volatility of the rupee will undo a lot of the wrong incentives that the RBI policy of “controlling volatility” had created. A fall in hot money inflows, more reasonable levels of foreign exchange reserves and lesser problems in managing liquidity in the economy, are some of the pay-offs that will emerge if RBI continues to stay away from currency markets.