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Guest Column/Ajit Dayal

Well done, RBI!

For those who think there have been only criticisms and complaints about what India ought to be like, this article praises the few brave men in the Reserve Bank of India who have saved this country from doom. At least for now.

The RBI's decision to raise the bank rate by 2 per cent has been criticised endlessly: a step in the wrong direction (like giving up your Tata small car for a chariot); a move that questions the thrust towards reform; an action that betrays a lack of faith in policy announcements made just a few months ago; a hasty decision that will take its toll on the economic recovery and plunge this country into a recession; etc, etc.

Wrong, wrong, wrong! Let’s put this episode in context. For the first time in decades, India had a relatively stable currency under former RBI governor C Rangarajan, and this fact, combined with the changes in laws that allowed foreign multinational investment, saw increased foreign exchange flows into the country. This has kept the Indian currency relatively strong, which has probably hurt India’s competitiveness in the export markets and encouraged imports. But a stronger flow of foreign money from multinationals and stock market investors paid for the higher trade deficit from slowing exports and increasing imports.

There are various economic theories to suggest what an exchange rate of a currency should be. But like most theories, neither the real effective exchange rate, interest rate parity, purchasing power parity, nor some new theory that I have thankfully missed can really tell you what an exchange rate should be right now. To misquote, "The forex rate is what it is, because it is what it is, and there is nothing to tell you why it is not what it should be, other than the fact that it is what it is". Basically, market price is when willing buyer equals willing seller. Any other price is fiction -- and theory.

Now, with this in mind, let us move to July 1997. Asian currencies got knocked out of shape, and not because of a sudden change in economics (unless you are telling me that the world and all the people investing in Asia were blind, stupid, or too busy to read published facts). It happened due to some change in this willing buyer and willing seller equation -- the punters then flew in for the kill. Simultaneously, you had a situation where the RBI and government officials made some very grandiose statements about how the Indian rupee was all set on a course for convertibility and joining the free market forces of the world.

Suddenly, forex punters realised that willing sellers could outnumber willing buyers and the Indian currency could fall -- the next target in the Asian domino game. And while the rupee slipped in anticipation of a speculative attack in a free-trading environment, the government officials made some "it is okay" and "a slight depreciation is necessary" noises. Sure, tell a tiger who is about to rip the flesh of your bones "just a little more, and then stop" and he will pause, excuse himself, and walk away. Ha!

Add to this a change in the governorship of the Reserve Bank, an election in the country, the final masala of Indian companies scared of products being dumped from Asian countries and lobbying to weaken the currency, and you have the recipe for a plunging rupee. In December, the central bank tried to stop this slide by limiting overnight outstanding trades (a polite word for satta) by banks, raising interest rates on export credit, and increasing the cash reserve ratio to suck out loose money used by the punters. The critics came down heavily on this and said it was a reversal of policy. Foul, they cried, how can we ever trust you? They forgot that policy is the means to an end, not the end in itself.

Others said that higher interest rates would lead to a recession. Since 1996, interest rates have fallen from 20 per cent levels to 12 per cent levels; did that cause a boom in the economy? Sure, keeping an economic recovery going is important but the time lag between high interest rates and a recession is probably one year -- not one week!

Which gets me to the next point: what is the objective? To make India poor, or make India rich? Since 1980, the Indian rupee has fallen from Rs 9 per dollar to Rs 39 per dollar and those explosive exports have not resulted in a huge forex reserve -- the exporters lied to us when they lobbied for this fall in currency. Instead, India has become poorer by 75 per cent because our wealth is measured in dollars (it happens to be the international benchmark currency and the dollar has gained by 430 per cent against the India currency in 18 years). Maybe we should keep the currency stable and allow the multinationals to evaluate investment decisions assuming a stable exchange rate instead of a 7 per cent slide in the rupee’s value each year.

If a richer India is the objective, then a stable forex rate could encourage multinational flows, and higher interest rates will punish the 10,000 punters and please 950 million people. This seems to be a policy worth trying, as the past policy of depreciating the currency has not led to an export boom, has made a few exporters rich, and decimated the wealth of 950 million people.

Well done, RBI. Keep interest rates firm through March 31 and let's see how the corporates and banks who ganged up to break the Indian currency declare their losses in their financial statements. For too long now, have so few been rewarded at the cost of so many -- it is time to change that. But if the next government’s first policy announcement is to weaken the Indian rupee, it won’t be difficult to figure out which lobbies funded their election campaign.

Ajit Dayal is an investment advisor and head of Quantum Financial Services, Bombay.

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