THE GIST of Editorial for UPSC Exams : 12 JUNE 2019 (Currency management needs an overhaul (The Hindu))

Currency management needs an overhaul (The Hindu)

Mains Paper 3: Economy
Prelims level: Currency Management
Mains level: Overhaul for currency management

Context

  • The chorus for reduction of real interest rates as the panacea for the current economic slowdown is getting louder.
  • From commentators to administrators to economists, that seems the only item on the menu these days.
  • The macro imbalance is a result of allowing excessive capital flows.
  • As a result, the exchange rate has ceased to be competitive.

About Currency management

  • Interest rates (nominal and real), inflation, forex rates and reserves, investments, capital account convertibility and foreign investment flows (all from the input or causative side) and growth, output and employment on the resultant side are intricately interconnected.
  • There seems a need to look at things comprehensively and evolve a framework agreement between the RBI and the government.
  • The actual rates post facto have consistently been lower (far lower) than the forward rates (rates quoted today for dollar that will be delivered say three, six months later).
  • The first one is determined based on the difference in inflation rates over the period concerned, and the second one based on difference in nominal interest rates.
  • If the real interest rates are deducted from nominal, then the movement in both should be determined by difference in inflation, provided there are no excess capital flows vis-a-vis the CAD.

Overhaul for currency management

  • The persistence of actual rate being way less than forward rate represents a serious imbalance and causes problems in domestic competitiveness, flow of foreign currency, investment absorptive capacity, etc.
  • For example, if apples (representative of a basket of goods) are selling at Rs 50 in India and $1 overseas, then exchange rate should be ideally 1$ = Rs 50.
  • Say, next year Indian apples have suffered an inflation of 10 per cent and have gone up to Rs 55. But apples overseas have suffered an inflation of 2 per cent and gone up to $1.02.
  • Then the exchange rate should be Rs 55/1.02 = 53.93.
  • But if the exchange rate is kept at say Rs 51, then the Indian exporter will get 1.02$ X 51 = 52.02 Rs /apple while he is able to get Rs 55 selling it domestically.
  • Why would he export? To overcome this, we should allow the Re to correct.
  • This will happen if we match the $ supplies into India with its net exports.

Contours of a new framework

  • The framework pact between the government and the RBI should cover all essential variables, not just one or two in isolation. Such an agreement should cover the following.
  • Limits on forex inflows: The inflows should be calibrated to match the absorptive capacity of the economy and its investment needs. While capital account convertibility can remain, RBI has to limit the quantum either at total levels or under each major source of inflow. Reserves are a costly loss-making insurance asset (much like gold with individuals) whose costs are far more than the difference between interest earned and paid. IThe limits can be +/- 1-2 per cent of what is required to plug the CAD or 6 months’ imports +/- 2 weeks.
  • Maintenance of competitiveness: Competitiveness comprises two elements — the physical and the currency. Physical competitiveness comes from technology, scale, skills, IPRs, and natural resource endowments over which neither the RBI nor the government may have control. Currency, distorted by capital flows, needs to stay competitive which can be achieved only if it floats freely to reflect the inflation differential.
  • Forex rates: RBI should be mandated to maintain the REER values (now the exchange rate is far lower than the REER value). The present massive divergence can be settled now on a one-time basis, with no more than 2-3 per cent deviation being permitted subsequently.
  • Recalibrating REER values: Again, instead of using the general inflation numbers of the countries to arrive at an REER band, it should be the inflation of major input costs (including interest costs) of goods and services traded between India and its major trading partners.
  • There are real dangers of currencies as a whole being governed by factors other than what determines competitiveness.
  • Real interest rates:Real interest rates should be mandated to be within 5-10 bps spread over interest rates in competing countries and those investing into India. High real interest rates and overvalued currency may encourage debt flows more than investments in real assets and FDIs.
  • Inflation: Divergence between estimated actuals and realised actuals after the end of period is difficult to control even for items like forex rates. It’s time we move on to inflation targets for 3-4 major groups. Food inflation is more politically sensitive and socially damaging than white goods or real estate.
  • Stability of laws: The last 4-5 years have seen sudden sharp changes in rules governing provisioning, NPAs, default status, etc. and levels of support to distressed assets even those which are clean but facing stretched cash flows. Changes should factor in reasonable adjustment period.

Quid Pro Quo

  • If these are corrected, governments should undertake to do the following:
  • To stay within the 3-4 per cent fiscal deficit targets,
  • To smoothen MSP increases based on fundamentals rather than subject to political whims and fancies,
  • To curtail interest declared on mandated savings like PF, PPF etc.,and
  • Not to announce arbitrary minimum wages.

Conclusion

  • The current economic impasse is arising out of highly overvalued currency, uncompetitive real interest rates and inflows far in excess of absorptive capacity.
  • The entire burden of spurring growth and employment hence falls on the government which has to substitute for the private sector, rendered uncompetitive due to these imbalances.
  • An agreement on the above lines would go a long way in kick starting growth and employment.

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Prelims Questions:

Q.1) With reference to Deep Ocean Mission, which of the following statements is/are correct?
1. It is an initiative of the Ministry of Petroleum and Natural Gas.
2. It aims to extract the shale gas from the Indian Ocean basin.

Select the correct answer using the code given below.
(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Answer: D
Mains Questions:

Q.1) What was true then of the US is true today of China which has proved far more nimble footed than India? Comment.

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