RBI's exchange rate policy should favour exports, but it doesn't

The daily movement in exchange rates should favour exporters, and not importers, in a visible transparent manner. The RBI owes this to exporters, says Sonali Ranade 

The Reserve Bank of India has no explicitly stated exchange rate policy. 

The reforms of 1990-91 started with a one-time much needed 20 per cent devaluation.  Since then the official line has been that markets, meaning demand and supply for dollars, determines the exchange rate. That line is belied by the recent 20 pc devaluation of the INR effected in July 2011.  [See appended USDINR chart.] 

The reality is that while overall demand and supply is allowed to determine the day-to-day rate, there are periodic behind-the-scenes interventions to effect major realignments once in a while -- which usually turn out to be 20 pc haircut devaluations!

The markets, and exporters and importers, leave alone long-term users of the market such as industry and entrepreneurs, have no clue as to what drives rates. Hence, investment in the economy, particularly in the export sector, is not guided by a clear-cut exchange rate policy. That in turn leads to under-investment in the export sector, leading to persistent supply side constraints on exports even where India has a demonstrable competitive advantage.

It is time, therefore, for RBI to stop pretending about markets driving exchange rates. It is imperative to ensure that investments in the economy are optimised automatically to eliminate persistent current account deficits. Such myth-making does nothing to address the persistent and ever-widening current account deficit that constraints India’s overall GDP growth.

To understand the problem in its correct perspective, we need to distinguish between two types of flows in the exchange markets. 

The major components of the aggregate flows in and out of the exchange market are on the trade account comprising inflows of dollars from exporters and outflows of dollars by importers. These may be called merchant or trade flows and here India has a huge deficit caused by persistently large imports not offset by export of goods and services. The other is investment flow and these are really the mirror image of trade flows. They are a result of having to borrow, or sell the family silver, to finance our imports, and need to be carefully distinguished from trade flows.

The imbalance in trade flows is the problem to focus on. It has got to be corrected because in the long run such deficits need to be financed by borrowings or selling the family silver to foreigners. The capacity to borrow and sell the family silver has its own limits. The fact is, 65 years after recognising the problem; we have just not invested enough in the export sector to achieve a balance in the trade flows. 

We need to explode the myth that we can’t export enough. Exports are a function of price. If that’s not so, let us not pretend to believe in markets and their efficacy in resource allocation. We have huge competitive advantages in labour-intensive agriculture, industries like textiles, leather, engineering goods, and services like software exports. There are ever emerging new opportunities like engineering and medical services. What is lacking is not the opportunity for exports but the will to invest in it by creating a supportive, long-term, empowering policy environment. 

In passing, one may note that the hidden bias in policy has always favoured transfer of profits from agriculture to industry. This is not obvious unless you see it in the context of cash crops like cotton. To favour “development” of local industry, policy tried to keep cotton prices below international rates to give the textile industry cheap raw material.  Cotton prices were controlled but not textile prices. Exports of cotton and imports of textiles were banned. 

Did we get a vibrant textile industry as result? No, actually this hidden subsidy to industry killed it by encouraging rent seeking. Similar policy biases against exports where we have a clear competitive advantage abound and persist even after liberalisation. Don’t blame the industry for maximising its profits. That’s what they are supposed to do, never mind the sagging exports. It’s our job to get the policy right, not theirs.

We let wholly extraneous farmers-versus-industry subsidy issues on cotton, or labour related issues in modernising the textile industry, kill the industry itself rather than exploit our competitive advantage in international markets. In one stroke, textiles alone can eliminate our persistent CAD. It is our inability to efficaciously sort out internal policy, stakeholder conflicts, and other similar issues that constrain exports, not lack of markets. China prospered in textiles. We killed our industry. Both happened in the same period of time!

Therefore, the perennial argument that “structural constraints” limit exports needs to be killed once for all. You cannot keep postponing addressing the real structural constraints because they are structural. Sixty-five years is a long time!

The exchange rate needs to be determined by the real trade flows generated by the trading action of exporters and importers and NOT by overall supply and demand for dollars.  The RBI has allowed the distinction between the two to be blurred. 

Investment flows are financing decisions to fund the trade deficit. Thus, when India borrows to finance the trade deficit, it creates an external liability and uses the borrowed dollars to pay for the excess of imports. These borrowed dollars are not the same as earned dollars. Borrowed dollars need to be repaid. And there is a limit beyond which nobody will lend these dollars to us. 

However, the RBI’s mantra of mixing investment flows with trade flows means the artificial supply of borrowed dollars get treated as earned dollars; and goes on to affect the exchange rate in the forex markets which is totally absurd. 

Portfolio inflows are no different from borrowed dollars. 

These are dollars we get by selling equity in future profits and other assets to foreigners.  There is a limit beyond which we cannot sell equity in our businesses to foreigners without giving up control over our own assets. Likewise, these portfolio inflows have to be serviced through dividends and eventual repatriation. The liability on portfolio inflows is not as well defined as on loans. Nevertheless, it is very real and usually far higher than on loans since portfolio investors take on higher risk than lenders.

Pretending that aggregate demand-supply drives the exchange rate means our act of selling the family silver and borrowing actually results in an appreciation of the INR, which is simply ridiculous as it compounds the underlying problem. This unintended effect of flawed exchange rate policy is not just theory. We see the impact of portfolio flows day in day out in the forex markets.

The very fact that the RBI has to effect periodic haircut devaluations of the INR every 10 years or so shows that the markets are failing to correctly price in the persistent trade deficit on their own, necessitating policy intervention by the central bank. One reason for market failure is the mixing of trade-related flows with dollars borrowed abroad and portfolio inflows. There are other reasons for market failure as well and one such is the skewed way the RBI corrects the CAD imbalance through policy intervention.

Take the USD-INR rate from 1997 onwards. What we see is a generally depreciating rupee viewed over 16 years but this includes three policy interventions by the RBI through haircut devaluations marked on the graphs. Exclude the policy interventions and we have a generally appreciating INR!

The psychological impact of a generally appreciating INR is simply devastating on exporters. For one thing it can be calculated. It varies from two to three pc over a 180-day period, generally the time lag between export of goods and inflow of dollars. This subtracts from the profitability of exports as the exporter gets fewer rupees than he expected, while his costs were in dearer rupees. 

Haircut devaluation is sudden, one time, and cannot be factored into the profit matrix even if the exporter could somehow capture it. It is something that happens once in 10 years while the loss of profitability due to an ever-appreciating INR is not only real, but also readily apparent.

No wonder exporters are demoralised, importers are happy, and India loses through under-investment in the export sector. 

The RBI can argue that over the last 23 years, the INR had depreciated considerably but that’s not enough. The daily movement in exchange rates should favour exporters, and not importers, in a visible transparent manner. The RBI owes this to exporters. 

The RBI can easily achieve this by distinguishing investment inflows from merchant flows. The relevant data regarding portfolio flows is reported to RBI/SEBI on a daily basis. It should be easy for the RBI to set its daily buying rate for dollars such that the dollar appreciates against the INR at some steady rate justified by the underlying merchant flows, ignoring the investment flows.

The RBI can set its sell rate for the dollars wider to avoid getting hit on both sides and let the market play its role in balancing demand and supply. Over a year or so, the markets will get used to the new structure and learn to discount RBI rates in advance, obviating frequent intervention. This will also effectively let the exchange rate reflect trade flows on a continuous basis, obviating disruptive haircut devaluations. 

The RBI’s act of setting a daily buying rate doesn’t mean taking away from the market.  It is a one-time structural reform that makes the market grow to be more efficient. It is not a return to the old administered system. It is merely a remedy for an unintended anomaly created in the market by faulty policy.

Over and above the segregation of trade-related cash flows generated from borrowings or portfolio investments, the RBI needs to incorporate other elements of a national strategy for exports in its explicit exchange rate policy. I hope to revert to the topic in subsequent articles.

Sonali Ranade is a trader in the international markets