Mains Paper 3: Economy
Prelims level: Currency Management
Mains level: Overhaul for currency management
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
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,
For example, if apples (representative of a basket of goods) are selling
at Rs 50 in India and $1 overseas, then exchange rate should be ideally 1$ =
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
Why would he export? To overcome this, we should allow the Re to
This will happen if we match the $ supplies into India with its net
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
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.
The current economic impasse is arising out of highly overvalued
currency, uncompetitive real interest rates and inflows far in excess of
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.
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
Q.1) What was true then of the US is true today of China which has proved far
more nimble footed than India? Comment.