Flip-flops in communication

After a long period of silence, the Reserve Bank of India took a number of steps to check the fall of the rupee. However, some of its recent moves have been intriguing and to some extent inconsistent as well.

A strategy to combat the falling rupee on an urgent basis is welcome.

However, it is important to take into account the likely impact of some of those measures on the macroeconomy. Boosting foreign exchange flows into India (to augment supply) is no doubt important, but specific steps in that direction will have to be in harmony with existing macro policies.

If they do not, they may convey an impression of desperation, which the government and the RBI would most certainly like to avoid.

Unfortunately, policymakers might well have fallen into that trap. The government has announced a number of relaxations such as enhancing the ceiling on investment in debt instruments (corporate bonds and gilts) by foreign institutional investors, reducing the lock-in period for foreign investment in infrastructure bond and removing the interest rate cap on external commercial borrowings by Indian companies. Each of these is significant by itself and would probably have found a place in the economic calendar over the next few years.

The problem arises because of a possible miscommunication. These ought not to be projected as necessary, urgent steps for rescuing the rupee at this juncture.

Since these measures have come at a time when overseas investors' belief in India's growth story has been faltering — the declining stock markets and, of course, the falling rupee bear testimony to this — it is to be seen whether they would have the same impact that they would have had in more normal times.

Encouraging foreign capital flows into debt markets is fraught with risks, a caution that the RBI has been heeding until now.

There are existing concerns over the ballooning short-term external debt. Will not the greater leeway proposed for Indian corporates to borrow from abroad increase the risks?

NRE deposits and arbitrage

The deregulation of interest rates on non-resident external accounts is intended to boost NRE deposits with Indian banks. The attraction is that these funds come in from abroad.

Banks in India are now permitted to offer their non-resident customers the same rates they offer to their domestic customers. This opens the possibility of large-scale arbitrage: the overseas Indians can raise dollar loans at incredibly low rates from a bank abroad and deposit them in Indian banks under the NRE scheme to earn fabulous returns. The interest difference can be very large — even going up to 6 per cent. The risks are minimal. The NRE schemes generally guarantee repatriation although they do not cover exchange rate risks. (FCNR accounts are maintained in foreign currency).

Past experience should warn us against relying on such deposits. They are known to flit in and out of India. Drastic interest rate changes in India or abroad will impact immediately on the viability of the schemes built on arbitrage.

Targeting speculation

In a surprise move, the RBI clamped down on speculation in the forward foreign exchange markets. It has disallowed cancellation and rebooking of forward contracts, placed limits on hedging by traders and foreign institutional investors and reduced the amount of dollars that authorised dealers can hold overnight. In RBI's view, speculation has had the effect of weakening the rupee

As soon as these measures were announced on December 15, the rupee reversed its decline but by the beginning of the following week resumed its declining trend.

Effective economic management, including exchange rate management, anywhere takes into account psychological factors that influence market forces.

The quality of central bank communication to the markets has become crucial to the success of monetary and related policies. In India too, there have been occasions when policymakers have successfully ‘talked up' the rupee's external value. During the recent bout of the rupee's weakness, the statements of senior government and RBI officials that there are definite limits to intervention and that ,in any case, the central bank will not ‘sell too many dollars' to defend the rupee, most probably undermined the central bank's belated defence of the rupee.

A more beneficial strategy would be to stress on the positives, which India still has in plenty. The economy might be faltering but even a sub-7 per cent GDP growth rate will still be commendable. Foreign exchange reserves are comfortable.

The recent upward revision by Moody's, of three key Indian debt instruments, shows that the India's economic performance is not all that bleak.