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Under-valuation or volatility?

August 14, 2003

In Jane Austen's novel Persuasion the heroine's father, Sir Walter Elliot, never reads any other book but the Baronetage.

Invariably the page at which the volume opens is the one that records his own entry. This he can read with undiminished interest and indeed we are told he reads nothing else "for his own amusement".

With Internet, such narcissistic opportunities are now available to many and most particularly to columnists and writers.

On typing 'Sudhir Mulji' Business Standard or even a general search engine like Google provides a string of articles, which I, unlike Sir Walter Elliot, find impossible to read, unless they are so old that I can no longer remember the gist of the argument.

However the Internet is also less discriminating, for not only does it provide under my name my own writings, but it also picks up all criticism by others who may have been provoked into responding to something I have written.

One such criticism was made by A V Rajwade on my advocacy of greater flexibility for the exchange rate.

Rajwade thinks that the Reserve Bank of India has avoided volatility by excellent management of the exchange rate; he cannot see any particular merit in greater flexibility.

In the normal course I would not choose to respond to a minor disagreement among friends through this column, but since there is such a strong interest in India's exchange rate policy, there may be some merit in continuing this dialogue in public.

One should begin by pointing out that there have always been two sets of exchange rates, one managed and controlled by the authorities, and the other, a clandestine 'hawala' rate, illegal but totally flexible and uncontrolled by any authority.

It is when the official rate over-values the domestic currency that the hawala market becomes active.

So strong was the participation in the hawala market that in my experience every taxi driver from Dubai to Doha was fully alive to both official and unofficial rates in the rupee dollar market.

In Dubai gold traders know with remarkable precision the rates they can realise for their dollars or rupees.

An early revelation to those who have struggled with Indian Exchange Control regulations was the discovery that the demand for foreign currency from residents was matched by an active demand for rupees from those who worked abroad. That is how the hawala market was created.

But there was a difference between the psychology of buyers and sellers. Residents who wanted to buy foreign exchange were relatively indifferent to the exchange rate; in economic language their demand curve was inelastic; on the other hand sellers of foreign exchange were concerned with the price they were paid, that is to say the supply of foreign exchange seemed relatively elastic.

It is one element of the success of managing of the exchange rate that the hawala market has been more or less eliminated, partly because the Reserve Bank has so liberalised its exchange controls that Indian residents can get what they want through ordinary banking channels but also because the authorities have maintained an under-valued exchange rate and added surpluses to the Reserves.

The growth in Reserves and the fact that a substantial portion of Indian BOP credits are from remittances suggests that the authorities are deliberately purchasing foreign exchange and therefore under-valuing the domestic currency, not for exports but simply to swell the Reserves.

Rajwade claims that the exchange rate is managed by a careful analysis of the real effective exchange rate, but it is almost certain that the RBI while conducting many studies simply has no policy for exchange rates; that is what the authorities mean by saying that they have no target for the exchange rate but avoiding fluctuations.

However those of us who argue for more flexible rates are not as concerned about policy when the domestic currency is under-valued but the implications of this policy when and if the currency gets over-valued.

It is difficult for the authorities to change policy from maintaining stability to volatility when circumstances change. Market players become accustomed to a certain exchange rate and imperceptibly pressurise the authorities to make the exchange rate a target.

A preference for stability can be dangerous; an under-valued currency provides few problems but that is not the case if the currency gets over-valued.

In international markets the burden of adjustment is thrown on to the debtor country rather than the creditor country. The former is compelled to adjust its economy while the latter needs do it only voluntarily. That is the modern attraction for trade surpluses.

Those who advocate a managed exchange rate recommend a policy of deliberate under-valuation. They cite the example of China, or Japan in the sixties, for substantial growth in GDP through pursuing an under-valued exchange policy.

But the Indian economy has not yet shown that characteristic of spectacular growth in response to an under-valued exchange rate.

We must be grateful to Arvind Virmani who first showed Indian growth rates in the eighties and nineties to be some of the highest in the world, but at no stage did he link this to an exchange rate policy.

Indeed, Indian growth rates were as high during a period when the exchange rate was managed badly before the crisis in 1991 as after the crisis when the exchange rate has presumably been efficiently managed.

It should also be pointed out that the one common feature of Indian and Chinese policies has been substantial monetary expansion run by the two countries, financed in China by the banking system and in India by fiscal deficits.

This may have something to do with growth though economists would be reluctant to accept budget deficits as a policy for growth.

The other example cited is that of Japan as a country that had achieved fast growth rates directly attributed to an under-valued currency. Yet there is a cautionary tale to that story.

Japan's growth rate has for the last decade faltered in spite of an under-valued exchange rate.

Rajwade argues that the Japanese failure demonstrates that volatility in exchange rates has not provided any incentives for growth; but it has nothing to do with volatility but simple under-valuation.

It is estimated that a trade related balance of payments equilibrium would require an exchange rate below 75 yen to the dollar. The Japanese authorities would never allow their exchange rate to rise to such levels.

They have chosen to keep their rate permanently under-valued. In these circumstances it makes no difference whether the rate is flexible or fixed.

In fact Japan is the prime example of the dangers of sustaining an under-valued currency for a long period. Industry becomes very competitive and efficient in exports but the domestic market can only use the revenue earned for investment abroad but never for improving domestic growth rates.

Under-valuation of a currency has many advantages but if this mis-pricing continues for long it can create long-term problems by a misallocation of resources.

It is always wise to test the extent of the under-valuation by allowing the exchange rate to fluctuate. Such changes accustom transactors and policy makers to adjust their responses to the requirements of the economy.

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