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The Wrong Battle for the Rupee

(I wrote this for Pragati, in August 2013)

Freedom is a wonderful thing. In 1947, we got freedom of one type, in the very month this article is published. Yet, since then, we have constantly rubbished our freedom by imposing various rules and structures about smaller but otherwise normal things.

Taking away our freedom, bit by bit, were government rules on who could do what during the License Raj, and you were called out even if you did the right thing. Bajaj was once accused of building more scooters than it was licensed to, inspite of a year-long wait for most customers from high demand. A controller of capital issues would determine the IPO price for any company, which meant that before you sold your company to people itching to participate, you had a convince a bureaucrat. Freedom from many of these rules comes through a forced liberalisation 20 years ago, though successive governments have forced some licensing back on us

Remaining though, are rules that restrict you from offending other people, emboldening many to take offence to just about anything remotely negative. Or those that allow anyone to ‘take down’ a web page for something that offended them and it would immediately become illegal to not comply.

Our fight for the rupee is the latest drama in the freedom act. It is true that the rupee is falling. It is also true that it will impact India in a way that frightens us – it will increase inflation, it will make many companies unable to pay back their dollar loans, it will cause panic in what is a net importing country. And to fight it, we have chosen means of both excellent and dubious reputation. Among the excellent is the RBI move to restrict rupee liquidity. The theory is simple. There are some dollars, and there are some rupees. In the grand scheme of things, if the growth in the number of rupees is more than the growth in the number of dollars, people will demand more rupees per dollar, eventually. We are at the ‘eventually’, now.

So one answer is to restrict the growth of the rupee, and one way to do this is to reduce the access to ‘emergency’ money (which is created by RBI on demand) unless it is at very high rates – now, 10.25 percent. The grand scheme of things also operates in the grand scheme of time, which means ‘eventually’. In the last 16 years, the RBI has printed rupees with abandon, growing its own balance sheet available by an average 16 percent per year since 1997. Much, was required – the flow of foreign dollars was heavy in the mid 00s, and there was a mad rush to “build foreign currency reserves”, and so, the RBI would print rupees to buy dollars. And after 2009 when the financial crisis struck, the RBI decided that the correct way forward was to buy government bonds through ‘OMO’ auctions, in effect printing some more rupees.

While not solely responsible for the crisis, the excess rupee availability has been a factor in the rupee slide recently. When we did print, we were an attractive investment destination; so, even though we imported way more than we could export (a factor that typically would take down the rupee), we were ‘stabilised’ by foreign investment flows. Now, that flow has reversed, and the natural course for the rupee is a few floors below. The mechanism to remove rupees from the system is one that will, by its macroeconomic nature, take years to operate. Therefore an RBI statement that these things are short-term is like saying pimples are short-term to a teenager. In our age of instant gratification, if it hasn’t already worked it is too late.

So the other methods are used, which will have near-term results but cause long-term damage. Like forcibly cutting down imports of gold, and putting ludicrous customs duties. (You can’t easily put huge duties on what is an investment avenue.) Eventually, what will happen is the return of the good-samaritan-gold-smuggling-underworld-don.

More dubious is asking debt free, cash-rich public sector organisations like Coal India to borrow in dollars so that there are at least some investment dollars coming in. This essentially passes on the problem to the point when these companies need to return those dollars.

Or mechanisms that reduce trading. The RBI has decided that speculation is the problem, not the symptom. So now, there are limits on large positions in the hot currency futures market. Even before this position limit, the RBI would know that the trading in the exchange was a very small part of the overall trading of the rupee, including all the other parts of the world where it trades without the RBI sword hanging over it. But it had to be seen as doing something, I suppose.

And then, the mad mechanism of market intervention. The RBI routinely buys and sells dollars, intervening in the forex market. It can do so at inopportune times, and try to hit prices so they create an ‘impact’. Which, like a headache tablet, can give you relief only for a few hours. There is no other mechanism so opaque where our country’s printing presses are used on demand without any prior intimation – even when the RBI buys government bonds, it has to announce it a few days in advance and buy in a participatory auction. Yet, we let this dollar market intervention happen because it tells us the RBI is in control.

It is perhaps best we leave the rupee to go where it has to go, and only take steps that address the problem, not the symptom. The cutting of liquidity is a good move, even if it is longer-term. We will also have to reform our labour laws so that manufacturing interest returns. We will have to ease up on restrictions on the rupee so that at least the few countries that would like to use it for trade, can do so. We will have to change the way our government functions – read no freebies – so that the government’s deficit is under control.  We will have to make our people buy local – not by force, but because things manufactured here are better and cheaper. This might only happen at a dollar-rupee rate of 100, but as we get more efficient, we will get less dependent on dollar inflows – which, as we will find, make their way into our country chasing that very efficiency. Net result: a stronger rupee, almost like we never planned it.

The way you don’t disturb the natural flow of a river without consequences, the rupee can’t really be controlled if the move is strong enough. After trying what we have, it may be better to focus on the things that make it weak rather than the rupee’s exchange rate.

  • feltra says:

    Deepak ji, you really have a gift for making the obstruse things look so clear. But for your writings, I wouldn’t even know the different parameters in this. Your example of river is brilliant. And when the natural flow is blocked, the rivers take different paths – with catastrophic results. The law of unintended consequences is in full play.
    All this – everything we have mis-managed from Independence has come down to the Govt not doing this – the Govt not doing that – inspite of sage advice available at the times. Wonder if we can delink Govt from administration of the country.

  • Leo says:

    i have a question WHY is the RBI not raising rates ? u say bonds are owned by indians. unlike US. So those who are saving are rewarded right .
    My answer to this is political pressure.Asset prices could collapse which will stop hoarding real estate .

  • DJ says:

    I think now we have the reverse problem. If QE taper does not happen for many months, we will have a stronger rupee and while crude will be cheap, exporters will suffer as well as services, IT, etc. As Ajay Shah has pointed out, almost all companies benefit from a weaker rupee. So, now what? Is the govt going to reverse its position and ask people to buy *more* gold in order to weaken the rupee (sarcasm intended). This shows why the panic on a weak rupee was a mistake as the weak rupee was needed by the economy. By avoiding that and artificially supporting rupee using band aids, now we have a stronger rupee than we need and the opposite problem. So, where do we go from here? Many smart people seem to suggest that we should now prevent rupee appreciation beyond 60 and accumulate reserves, which has its own problems…. utter confusion 🙁

  • Leo says:

    the problem is not the value of the rupee it is sudden shortage of dollors and the volatility swings in RUPEE 50 57 64 68 .If i am not wrong India RBI doesnt have physical dollor reserves.Samething goes with china.Depreciation helps till system is stable.But think of the govt debt. The interest payments will add more pressure to the rupee.But yea 61.1 if it breaks 55 coming.THE RUSSIAN default was being backstopped in 1997 by IMF GOONS and US banks till LTCM blew up 1997 1998 .All banks got caught.So dont believe whatever they say.IT iS emerging market ATTACK check south african rand .10+ it will blow up 50% which is huge.
    the problem with mkt is that in good times it makes its own reason to be bullish.Gold oil is not the problem.THe minute rates rise internationally all the loans will called .the moment is not far off…
    In US they want that 17 trillion debt which foreigners own and same amount is in pensions.
    so Obama some how wants fill that equation and thinks they will be in control.
    So moment is very close i feel.Watching the EURO USD Pair 1.3848 it is very important .Coz euro picks up momentum USD will blow up to 74 DXY then what ? inflation in india will be even more and u will get gold OIL to all time high.
    another thing to watch is the US yields….they are not backing off…2.5 2.6 2.7 it is just moving around that .Chances are very high that it will go above 5 6% in a few months.

  • px says:

    Humans were supposed to be hunter gatherers, who settled to farming
    Congress policy is to have members of a family be benevolent dictator right since at least the last 30 + yrs …
    So Rahul goes the laloo way … what use is development and roads to a garib ? we will give u guaranteed food for free as ur right … right based vote gathering.
    RBI has been controlled by the govt since time immemorial and all democratic govts
    being inherently populist, would like to iron out the down cycle with intervention not caring about the reprecussions .. heck the family business connected to the hip with dlf even makes money out of it and out of the farmer compensation bill !
    Why was Subba talking sense and doing nonsense in terms of policy ?
    i can remember a whole lot of psu s ruined by policy to stay and enjoy fruits of power,
    be it the oil bunch now .. ongc oil hp bp etc which are stagnant or going down in mkt value…then we had IPCL whose takeover by reliance were facilitated by the people holding key offices now (minister of reliance in the polyester prince). Then there is UTI n UTI64, which were ruined by such policy.. Right now the whole damn psu basket owned by the People of INDIA and LIC …which is taking hits both on its debt and eq pf.
    The fundamental problem is the state policy, fiscal deficit and a profligate oligarchic / crony capitalist govt which wants votes at any cost and fill pockets with subsidy money on the side ! And their policy is not going to change overnite. So defending the rupee is paramount because fundamentals are weakened.
    Things and mentality is a lot tougher to change !