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Home > Business > Columnists > Guest Column > Surjit S Bhalla


Lessons RBI can learn from China

May 12, 2007

Somebody should answer, but obviously nobody ever does. The Congress party, via the finance minister, has been running the RBI for several months now, or so it would appear to most neutral observers.

There is nothing a priori wrong with this practice because the RBI is not independent of the politicians. But different political parties have chosen not to exercise their powers, with the present UPA government being the least restrained.

But has this political interference achieved much? The Congress party has lost one election after another, so the bright boys (or girls?) hit upon an even brighter idea - the losses were due to higher than expected inflation.

So in the grand Indian tradition of "when there is an accident one should ban all construction of roads", the FM told the RBI to reduce inflation at all costs. The RBI heeded the master and as requested went for overkill - interest rates went up, as did the rupee.

Two results have just come in: inflation in April has come in below expectations, and for the last six months is running at a seasonally adjusted rate of 4 per cent, i.e. well below the politicians' and the RBI's target of 5 per cent.

And the Congress lost massively in Uttar Pradesh; not only did it not gain 15 seats as per the lowest expectations, it actually lost three from the already low base of 25 seats. Oh, the injustice of it all, especially given a more than a 100-year-old dedication of the Nehru-Gandhi family to Indian politics.

The overkill means a loss that the economy must bear because of the recent political ignorance of economic realities. The rise in the rupee is the most inexplicable (among already some surprise inflation fighting policies like a dual excise rate on cement, banning the trading in wheat futures, etc).

There has been one consistent policy of all governments since the reforms of 1991 - the exchange rate has been kept moderately competitive. This has helped our exports to grow at a healthy pace for the last 15 years. In the last one month, the rupee has appreciated against the US dollar by almost 10 per cent. This will certainly help bring down inflation, but at what cost?

According to the mandarins at the finance ministry, at apparently zero cost. Didn't you know that the laws of economics had changed, that price no longer affects demand?

Ironic that this should happen with Manmohan Singh as the PM, for he wrote, long before it was fashionable, that exchange rates mattered for exports; ironic, because the PM's first act as finance minister in 1991 was to depreciate the rupee by 20 per cent in two days. Ironic, that he is PM while the finance ministry is practicing voodoo economics.

But voodoo economics has some facts on its side. Note that despite a constant nominal rupee and an appreciating real rupee, our exports have been growing at close to 20 per cent per annum for the last four years.

But look at the fifth column, which shows the median export growth of 21 Asian countries, and the sixth column, which shows the excess of our export growth (relative to the median).

The median export growth of our Asian competitors in 2006 increased by 18 percentage points over 2002; Indian export growth decreased by 1 percentage point! While we have been puffing our chests about export growth, our competitors have quietly been catching up.

In 2006, Indian export growth was more than 6 percentage point below the Asia median, i.e. one of the worst export growth stories!

What this simple exercise shows is that in order to assess whether exchange rates matter for export growth, one needs to control for the external environment. If a rising tide of world trade is lifting all boats, then just looking at our own rise is not only bad economics, it is bad accounting.

There is yet another argument made by those who argue that the exchange rate should be allowed to roam freely. It is that in order to keep the exchange rate competitive or undervalued, one has to constantly buy dollars, and park these dollars at rather low rates abroad.

India has about 200 billion dollars in reserves; the rate of return domestically on rupee deposits is about 8 per cent while US dollar deposits fetch only 5 per cent. So India is losing about 6 billion dollars annually by intervening in the foreign exchange market (as the RBI was successfully doing for the last decade or so). This is a straightforward calculation.

The relationship between export growth and the lagged RBI trade-weighted real exchange rate is about 0.5, i.e. each 10 per cent depreciation adds 5 per cent to export growth.

More complicated is the calculation of how much the economy gains with an undervalued exchange rate, a topic explored at length in my new book.* The bottom line: each 10 per cent real depreciation adds at least 2 per cent to GDP, or given our trillion dollar GDP, that is at least 20 billion.

By not intervening in the FX market, the exchange rate has appreciated by 10 per cent in the last couple of months. How much less reserves will the RBI accumulate given this lack of intervention? Let us be generous and say $20 billion; on each $20 billion we gain 3 per cent, so India comes out ahead by $600 million.

On GDP growth we lose $ 20 billion. So gain $600 million and lose $20 billion is the new FX policy. This simple benefit/cost analysis suggests that it is a no-brainer to keep intervening in the FX market and keep the exchange rate competitive, as we had successfully done so until the new seemingly harebrained ideas of FX management.

Such new ideas should be held in abeyance, at least until the 1300 lb gorilla to our north stops monkeying around with its exchange rate.

We should learn from them about modern macro-economics - about keeping the exchange rate undervalued, low inflation, and high economic growth. I suggest that the finance ministry send our esteemed Deputy Governor Rakesh Mohan to China to learn how to manage the exchange rate.

Not that he does not know how, but the fact that China can do it, and therefore so can we, might resonate well with our politicians.

*Second Among Equals: The Middle Class Kingdoms of India and China, forthcoming, Peterson Institute for International Economics, Washington, DC, 2007.

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