Since April this year, I have spoken to at least 200 companies, all of whom had been significantly affected by the sudden appreciation of the rupee. Interestingly, very few of them -- only 3 or 4, as I recall -- were still shaking their fists and looking for the government (or the RBI) to do "something". Interestingly, also, very few of them were adjusting their receivables forecasts downwards in dollar terms, although rupee margins were obviously being squeezed. And some of them, including, incidentally, one of the few old guard left, were looking to raise capital to diversify into the domestic market.
However, all of them agreed that, rather than rupee strength per se, it was the suddenness of its upward movement that had put them into trouble. There is little doubt that most companies would be able to manage their businesses quite well even at the current exchange rate if the move towards 40 had been smoother.
Granted this is not an easy task, and the RBI deserves some marks for its efforts. However, I believe that allowing the market more play -- intervening less frequently -- would have created a smoother ride. And, indeed, would be more in tune with the market function of a central bank, which has been described very elegantly by one of my most trusted gurus (my father), who has often said, "The central bank should be like God; you know he/she/it is there, but you only encounter him/her/it during a crisis."
Witness, for instance, the US Fed (or the ECB or the Bank of England). Its primary focus is definitively on inflation and interest rates (which affects growth and employment); only if things get out of hand -- as, indeed, currently -- does it turn its operational tools to micro market elements, like liquidity and/or the value of the currency. And significantly, even though the dollar is trading at an all-time low on a trade-weighted basis, the Fed's focus on the dollar is less on its actual value than on the concern that if the Fed were to cut rates aggressively it might trigger a wholesale collapse in the currency.
The RBI, on the other hand, has an obsessive focus on the value of the rupee. Notwithstanding its disclaimers, few people have any doubt that it is the actual value (and not just the volatility) of the rupee that drives decision-making.
Earlier this year, for instance, the RBI poured billions of rupees into the market, buying dollars almost daily to protect the 44 USD/INR level; the net impact, of course, was a surge in money supply and, with it, inflation, till the RBI had to give up the ghost, leading the rupee to shoot higher, destabilising, as reported above, most businesses. (Again, currently, it has girded itself to try and keep the rupee at around 40.50.)
The problem is that this constant and continuous activity in the market creates a moral hazard, to use a contemporarily popular term, since it leads market users to believe that the RBI will always be there to protect a particular level or range. The reality -- and we have seen it often enough -- is that the RBI cannot protect a particular level or range for too long, because the market, like water, will always -- and continuously and forcefully -- seek the correct level.
What is that "correct" level for the rupee today? I don't know, and, more importantly, neither does the RBI (or anyone else). I mean, it was trying to protect 44 six months ago, and is trying to protect 40 today. Who's to say whether that's the right level? Why not 38? Or 42, for that matter? There are certain academic models -- REER, for instance -- but none of them can really capture the complexity and dynamism of any economy. In reality, the most efficient -- or "correct" -- exchange rate at any given point in time is much too complex to calculate. A free and liquid market provides the best guesstimate.
So, rather than continuing to micromanage something which is basically unmanageable, it would be far better to allow the market more play and, importantly, move forward rapidly to enabling that freer and more liquid market.
Granted this may lead to an even stronger rupee from time to time -- currently, for instance, the rupee would likely strengthen to 39.50 or so (my guesstimate) -- but it would also result in genuine two-way movements in the market, smoother volatility and a much more efficient market for risk management.
Not that I'm saying that the RBI should never intervene. Rather, as I have said earlier, the intervention should be less frequent, and, importantly, should be focused on ensuring an orderly market. This cannot be achieved by trying to hold the rupee at a particular level (or range) -- since this would only coincidentally by the "correct" level, any such effort (as we have seen often enough) would lead to a build-up of pressure one way or another till, sooner or later, the market would explode away from that level. Nor can it be achieved by trying to keep the volatility of the rupee at a particular level -- again, this is a parameter for which there is no method of assessing the right value.
To my mind, the RBI's intervention should be designed to ensure that the volatility of the rupee doesn't jump around too much, since it is this jumping volatility that makes risk management much more difficult. Such an approach would certainly lead to less frequent intervention, a stabler market, and would enable Indian companies to make sounder asset allocation decisions.
Of course, this needs the RBI to repose its faith in the market, which is, after all, just another creature of God.
Ganpati Baba Moriya!
