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Fears for the rupee hold back tears for the onion

Last Updated: Sat, Aug 24, 2013 19:01 hrs
At Rs 80, onions bring tears

In the world of television talk shows, op-ed columns and social media debates, where everyone is an expert on everything, the latest area of expertise for the commenting class is monetary and financial economics. Driven by the continuing depreciation of the rupee being the daily headline, much, if not all the discussion in both domestic and foreign media, has taken on a somewhat alarmist turn.

Some analysts suggest that India is yet again on the verge of a macroeconomic crisis of the type it experienced in 1991, which jumpstarted the economic reform process. Others, and this includes many academic economists, argue the rupees fall is a natural reaction by the markets to continuing large fiscal and current account deficits, persistently high inflation, and a general loss of confidence in the countrys economic prospects by both domestic and foreign investors, as well as continuing economic global uncertainty and the prospect of tighter monetary policy in the US.

While the government will have us believe its only global factors that are to blame, and the opposition parties want you to believe its only domestic ones, the fact is that both a weak domestic economy and a jittery global financial market have conspired to create the perfect storm for the rupee. Perhaps this would be a good time to put things in perspective and not get lost in the minute-by-minute tracking of the rupee on the television ticker.

As the Nobel prize-winning economist Robert Mundell pointed out a long time ago, a government, through its central banks policies, could either control the quantity or the price of its currency but not both. A central bank which fixes the price of its currency in terms of one or a basket of foreign currencies, in other words, operates a fixed exchange rate system, loses control over the quantity of money that circulates in the economy and, therefore, loses control of the inflation rate.

During the Asian financial crisis of the late nineties, most Asian countries affected had fixed exchange rates against the US dollar and allowed capital to flow in and out freely. The problem was excessively high inflation in these countries meant that their exchange rates were overvalued and exports uncompetitive. This resulted in a loss of confidence in those currencies, foreign investors pulling out, and central banks reserves of foreign exchange dwindling by the day once the panic has struck. By the time the dust had settled, these countries underwent major macroeconomic and sometimes even political crisis, such as the toppling of the Suharto regime in Indonesia.

Indias situation is very different. Although the rupee is not fully convertible, there are significant flows of capital in and out of India which means that the rupees exchange rate is in effect a market determined and flexible exchange rate system.

This is where the second half of Mundells theory comes in: A central bank which targets the quantity of money (or the rate of growth in the money supply or alternatively a preferred inflation rate) essentially loses control over the price of its currency, the exchange rate.

Mundells idea that a central bank cant simultaneously control the inflation rate and the exchange rate in a world of open capital markets is often called the Impossible Trinity.

In the Indian context, that tells us that Reserve Bank of Indias policies which have been largely concerned with domestic economic conditions would mean that it would have to allow the rupees trajectory to largely be set by the market. Even intervention by the RBI in the currency markets can only attenuate slightly but cannot fundamentally change the market-determined course of the rupee, at the moment downward.

Its also worth remembering that Indias situation while perhaps worse is hardly unique among emerging markets. Many have seen a similar recipe of high deficits and high inflation leading to loss of investor confidence and depreciation of the currency. Another Nobel prize-winning economist Paul Krugman observed recently that Brazil, which he believes is the natural comparison for India among emerging economies, has seen an even more volatile trajectory for its currency than the rupee has witnessed.

A second point to remember is that a cheapening rupee is an effect rather than a cause of Indias current economic woes. A policy of trying to strengthen the rupee is not only doomed but is equally misguided since it does nothing to tackle the roots of the problem, the twin deficits and high inflation.

As has been pointed out by all sensible commentators on the current situation, rather than having the RBI tinker with capital controls, the only long-term solution is to get back on the road of economic reform, rein in excessive spending, and thereby create a positive rather than a toxic climate for domestic and foreign investors.

With an election looming, it seems unlikely the government will muster the political will to do anything much in this direction. In this second-best world we actually live in, rather than the textbook world where governments always follow the right economic policy advice, the most sensible policy would be to allow the rupee to depreciate, even if it overshoots and becomes undervalued relative to fundamentals. When the market senses that, some money at least will start flowing back into India and the rupee slide will be arrested and the currency will slowly begin to appreciate and return to its fundamental level.

No doubt the government hopes that this is what will play out between now and election time, with a falling rupee standing in as it were for the much-needed economic reform. More, if the governments public relations team understands basic economics, theyll point to the beneficial effects of a falling rupee on key export sectors such as information technology. This strategy of playing down the causes or consequences of the falling rupee may well work unless either an actual macroeconomic crisis occurs in the next few months or the falling rupee becomes a political liability for the government. With a still healthy level of foreign reserves, an exchange rate crisis isnt imminent, nor is it evident that the falling rupee is having much political impact except on middle class and rich urban Indians, directly affected because they buy imported goods, travel abroad, send their kids to study abroad and so on. So, while the English talk shows and op-ed columns are all about the rupee, most ordinary folks are still worried more about the price of onions.

While its true that depreciation-induced inflation could have knock-on effects on the prices of basics, but these indirect effects are arguably much less relevant politically. Its telling that on a day when the rupee took another dive, the chairperson of the UPA, Sonia Gandhi, was talking up the food security Bill. As the bellwether of whether economics is going to have a big impact on the coming elections, then, it would be worth keeping an eye on the price of onions at the same time as we look at the price of the rupee.

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