Exchange rates may have a bigger impact than interest rates.
There are three important measures of the value of domestic money:
· The inflation rate, which determines the domestic value or purchasing power;
· The interest rate, or time value of money, which measures what savers get or borrowers pay; and
· The exchange rate, which measures the external value of the currency.
While much debate and discussion has focused on the first two measures, in the process, one wonders whether we are overlooking the third measure, namely the exchange rate. Even as the dollar has strengthened in international markets in recent weeks, the rupee has appreciated from Rs 44.88 per dollar on December 13, to the current level of around Rs 44.10. Given the worsening inflation differential, in real effective terms, the appreciation is perhaps 4 per cent in the last two months alone. I estimate the current index value at around 110, way above the roughly +/- 5 per cent band the RBI was sticking to for quite some time. (Ironically, this is happening under the central bank stewardship of the person who, as deputy governor, had cautioned markets against the appreciation of the rupee in a now famous speech in the Forex Association conference in Goa. Is his current thinking influenced too much by the spectre of sterilisation?)
The appreciation of the rupee at a time when the deficit on current account could well come to 2 per cent of GDP (the EAC’s estimate is lower), is difficult to understand or support. While inflation is politically the most sensitive number, in terms of the economic impact, the exchange rate is arguably even more important than the interest rate. Firstly, the latter hardly impacts perhaps three quarters of the economy (services and agriculture). Secondly, the debt equity ratio of Indian industry has come down dramatically, and the cost of borrowed funds is only a small proportion of the total cost: for most businesses, availability matters more than cost. Thirdly, as even the votaries of monetary measures accept, the impact of monetary policy has a lag of perhaps 18 months. Since, over this period, other things are rarely equal, it is very difficult to estimate precisely the concrete impact of a monetary measure on price levels. In our own case, for example, monetary tightening began about two and a quarter years back, but on a year-on-year basis, inflation today is much higher than in early 2005. It can of course be argued that, but for the measures taken since October 2004, inflation today would be much higher — and, of course, there is no way to counter that argument.
On the other hand, the impact of exchange rate changes on the realisations or costs in the economy is direct and immediate. Last year, current account transactions totaled as much as 56 per cent of nominal GDP. But this apart, all commodity kind of goods produced and sold in the country — ferrous and non-ferrous metals, basic and petro-chemicals, and so on — are priced according to import parity. The exchange rate affects their prices too, immediately and directly. Is the exchange rate being used as an anti-inflation measure? This could have rather unwelcome repercussions on growth, employment and the current account balance. The monetary measures may well decelerate the economy without doing much for inflation, a proposition impossible to prove — or disprove!
While on the subject, one question rarely debated is the extent to which the external sector should bear the cost of inflation control, and what could be the long-term repercussions of such measures. Take the recent and suddenly imposed ban on export of skimmed milk powder. (There is also talk of banning rice and maize exports.) Such sudden bans not only affect our credibility as a reliable supplier, but in the case of milk powder, also the price which the producer of milk gets. It is perhaps high time that the authorities made up their minds between whether they would like higher prices for the producer or lower ones for the consumer. (Organised retailing may achieve both to some extent as a one-time effect, but otherwise there is no escaping the demand supply curve.) Talking of credibility, ours has hardly been helped by the complete mess in SEZ policy, the scrapping of duty credit on car export growth with retrospective effect, or the ordinance forcing the cricket ODI broadcaster to share the feed with DD. We surely have every right to insist on such a clause in all future contracts between the BCCI and the broadcaster — but not in respect of existing contracts bid on a different basis. Surely, investors, both domestic and foreign, are drawing their own conclusions from the cases of milk powder export and duty credits on cars.
Incidentally, I notice from the latest bulletin of the RBI, that it has faithfully copied the design of the European Central Bank publication. While the design is an improvement, is this an indication of also adopting ECB’s single point objective — inflation control? (ECB has no responsibilities for growth or employment.)