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Volatility and the exchange rate
Sudhir Mulji | May 15, 2003
It is a pity that even such a professional economist as Rakesh Mohan feels compelled to claim that the rupee exchange rate is determined by market forces.
He knows this to be untrue. He knows as well as all economists and analysts that if the Reserve Bank did not purchase all surplus dollars, the rupee rate against the dollar would appreciate quite substantially and that it is the RBI's action, which determine key exchange rates.
That may be a good thing but that is not the point. All one can safely say is that, the rupee exchange rates are not determined by the market but by the Reserve Bank.
It is perhaps useful to remind ourselves of some elementary economic theory; why do we prefer market resolution of prices and exchange rates? How does it matter whether the Reserve Bank sets the exchange rate or it is freely determined?
The answer is that it is fundamental to economic theory that free market prices reflect value or the relative utility of the goods to buyers and sellers. Since the purpose of economics is to maximise the utility, the general proposition that prices reflect utility is an important signal to determine value.
If the Reserve Bank buys dollars for utility to them, its intervention in purchasing dollars is economically justifiable. But, prima-facie at least, it would seem that the Reserve Bank has no utility for foreign exchange, not even the need to accumulate it for some future use.
It is a reserve perhaps that could be kept aside for a crisis, but we cannot learn too much from RBI's purchase. It is not a signal to the value of the dollar. RBI's policy seems to be to allow the market to absorb dollars that the business of the economy requires and then to buy all the remaining quantities at market price.
RBI considers itself to be a passive buyer and simply mops up surpluses at a price determined by the market. It is only in this sense that Rakesh Mohan can argue that the price of foreign exchange is market determined.
But it is an essential part of economics that prices and quantities are simultaneously determined. The two axes of the supply-demand schedules are drawn with prices on the vertical axis and quantities on the horizontal axis.
If a buyer is indifferent to quantity, the equilibrium price no longer reflects the market determined value because there is a buyer purchasing for which he has no known utility, no targeted quantity and no price constraint. This may ensure clearance of the market but it sends no signal as to the utility of the foreign exchange.
Such behaviour by an intervening agency may reduce the optimal use of foreign exchange, for there may be productive forces, which cannot afford dollars at present prices but might well be able to make use of them at lower prices.
RBI's passive intervention prevents the price of dollars from going down to the extent that it would without intervention. It is therefore necessary to seek active reasons for purchasing foreign currency and not just a passive reason.
There may be nothing economically unsound about RBI choosing to buy foreign currency but its intervention, whether active or passive, deprives others from using the dollars. It is not intervention itself that is wrong but if it is without any known or unknown utility then it is purposeless and unjustified.
For as already stated, RBI's intervention prevents those who have utility for dollars, but, at a lower price level. Thus the intervention is not as passive as it may seem.
Now, the reason RBI gives for its intervention is that it does not want volatility in exchange rates. Yet that policy traverses economic principles; if you discourage a change in prices you may not be able to rely on Marshall's supply- demand scissor to stabilise prices at their proper equilibrium.
Further, restraining volatility in one market may add to volatility in other markets. For as (Leon) Walras pointed out, all markets are inter-connected and there is no reason to assume that volatility is also inversely inter-connected.
Consider Hong Kong as an example of movements in volatility; its government policy is to maintain a fixed exchange rate. The consequence has been that whereas the exchange rate has remained rock steady, volatility has shifted to other free markets.
In particular, land prices and general activity have fallen dramatically. The burden of volatility has fallen on asset prices and economic activity, precisely because it was contained in exchange markets.
An economically speculative way of looking at volatility is to regard all economies as having a given degree of volatility within them. If you block one avenue for change, the pressure of volatility falls on other free markets in the economy.
Thus, RBI's policy of kerbing volatility in exchange rates, may have brought pressure on interest rates, and lack of olatility in interest rates may have spilt over to economic activity.
Rakesh Mohan has applauded the remarkable stability that rupee exchange rates have displayed in comparison to the recent volatility of the euro.
This does not seem a matter of pride. The relative inflexibility of the exchange rate does not seem to have produced economic benefits like increased employment or increased investment.
Apart from an admirable and welcome growth in foreign reserves, there has been no other obvious consequence of the stability in our exchange rate.
It is clear, however, that growth in reserves and the removal of exchange controls have been highly beneficial, particularly in an economy which had been plagued by endemic foreign exchange crises. If the accumulation of reserves was done for that purpose, the task has been well-done. It is now time to move on a few steps by demonstrating the use of these reserves.
For the paradox of economics, and the reason for economists to cling to fundamental concepts like value, is that a policy that seems both obvious and sensible does not always retain that quality. In this shifting sand it becomes necessary to re-examine and change policies to make sure we are on the right track.
For as with (Friedrich A) Hayek and Kahn on policies of unemployment, wrong signals may lead to bad policies. The story is that during the period of sustained unemployment Kahn asked Hayek the question: "Is it your view that if I went out tomorrow and bought a new overcoat, it would increase unemployment?" Hayek: "Yes, but it would take a very long mathematical argument to explain why."
The mathematics may not be easy but the general point is quite clear. Artificial policy distortions, either on quantity demanded or prices determined by free markets can ultimately disturb the allocation of resources. That is what the Reserve Bank should beware of. That is where mere accumulation without meaningful changes in exchange rates is bad policy.