A deadly defence

— Anonymous ancient proverb,wrongly attributed to Euripides

Starting July 15,the ministry of finance and the RBI initiated a set of policies to defend the rupee. These policies have consisted of all the disregarded currency defences that countries have mounted over the last 20 years or so. Short-term interest rates were raised by over 300 basis points,import tariffs were increased,and capital controls initiated. Is there any bad policy left? No.

How successful have these policies been? The rupee was just under 60 on July 15 and today is at 63.5. Bond yields were 7.5 per cent and are now at five-year highs at 9.3 per cent. And the stock market has taken a deep dive of more than 8 per cent since July 15. No matter what the calculation,the rupee-defence policies have gone massively wrong.

And predictably so. What is well known in government circles,to the IMF,academics,traders and most (but not all!) economists is that interest rates do not really affect the value of a currency. When has the interest rate defence worked? History suggests never. And the reason — the answer is so simple but possibly unknown to our policymakers — is because interest rate hikes only buy you a little time at best,and make the situation a lot worse later. As has just happened in India. An investor or trader who is shorting a currency needs to borrow rupees. The borrowing rate for rupees was raised by the RBI by close to 300 basis points on nightmare night July 15. Three hundred basis points for a year means an extra cost of 1 basis point for each trading day. So,if the rupee depreciates by 1 basis point,that is 0.01 per cent,the person betting on the rupee weakening has made up her extra RBI imposed cost!

The second reason the RBI policy was doomed to fail,ex-ante,is because,in my view and according to my research (see Devaluing to Prosperity: Misaligned Currencies and Their Growth Consequences),the only policies that help the exchange rate are acceleration in GDP growth and/ or deceleration in inflation. And symmetrically,a deceleration in GDP growth is a major determinant of exchange rate depreciation. The third mistake made by the authorities is in assuming that either domestic savings or foreign capital flows are affected by interest rates. They are not. Innumerable studies have documented that the relationship between savings rates and interest rates is non-existent; and an equally innumerable number have documented a negative relationship between growth and real interest rates. And a large number of studies,including those for India,document a positive relationship between growth acceleration and exchange rate appreciation. Not recognising this was the fourth major mistake.

Unlike most other financial markets,the exchange rate is also affected by politics. And if the ministry of finance and the RBI failed their Exchange Rate 101 exam,the political leader of the Congress,Sonia Gandhi,doubly failed her political exam. Introducing the food security ordinance,and then the bill,when the state of the economy is about as precarious as it has ever been,was foolhardy at best,at least as far as the rupee is concerned. No one has yet expressed the view that this measure will either increase economic growth,or increase confidence. And there is considerable research to show that the food security bill does not help the poor.

If this were not enough,a hot political controversy in the form of Telangana was dropped on the economy and the rupee. Yet another contentious policy which proved,beyond any reasonable doubt,that the Congress was a cold,calculating machine,with the interests of the economy,or the poor,

or the rupee,being the furthest from its imagination.

Is it any wonder then that the rupee is the worst performing currency in the world,and became worse during the last month?

The person (or persons) behind the politics of rupee destruction is easy to identify. Considerably more difficult is the identification of those responsible for the economic package. The contenders are several. From Delhi,there is the ministry of finance in the form of the finance minister,P. Chidambaram,and the new RBI governor,Raghuram Rajan. Could they have advocated defending the rupee by raising interest rates to defend the currency? The FM has been consistent in stating that India needs lower interest rates in order to facilitate growth. And from my readings of Raghuram Rajan’s numerous writings,it can be inferred,with reasonable certitude,that he could not have advocated the draconian,counter-productive measures.

So where does the needle of economic suspicion point to? Clearly,no matter who made the decision,the ultimate voice is that of the prime minister,Manmohan Singh. The one economic adviser the PM listens to on interest rates and associated macro-economic policy is C. Rangarajan,who is also rumoured to be extremely influential with D. Subbarao,the point official making the ill-fated RBI policy.

Speculation and identification of the officials responsible for the counter-productive rupee defending policy may ultimately be only of academic,and of some (future) policy interest. The most important question remains: what should the policymakers do today?

They should make a policy statement. As a preamble to this most important policy,they should state first that they recognise that the economy is in crisis. Second,and most importantly,state and recognise that the rupee defence policy has failed,and failed catastrophically. (This is murmured in private almost universally.) And issue the following policy statement:

“All the ‘new’ policy measures announced since July 15 are hereby revoked. We no longer believe in defending the rupee at any level,but we equally strongly believe that it is considerably undervalued,that is,the rupee is in wildly overshot mode,and is thus considerably weaker than its unknown ‘fair’ value. We are opening up swap lines with the Japanese,the European and the British central banks. If and when we deem it necessary,we shall initiate swaps (borrow dollars) from these central banks. The State Bank of India is issuing a $10 billion bond guaranteed by the government of India. And finally,revival and encouragement of growth will be the new focus of the government. In this regard,it helps that India has a new RBI governor. Go ahead,make my day,short sell the rupee.”

The writer is chairman of Oxus Investments,an emerging market advisory firm,and a senior advisor to Blufin,a leading financial information company