Tuesday, January 2, 2001
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Managing the impossible trinity 

Bimal Jalan  
Policy issues relating to the management of the external sector, particularly the appropriate exchange rate systems, intervention policy and foreign exchange reserve policy figure very prominently in ongoing discussions. Both in theory and practice, the state of debate is still somewhat unsettled. First, an important issue which has been extensively discussed is that of an appropriate exchange rate regime, particularly for emerging markets given the so-called impossible trinity of full capital account convertibility (CAC), monetary independence (for inflation control), and a stable currency.

If CAC is accepted, according to theory, you either have the choice of giving up monetary independence and setting up a currency board or giving up the stable currency objective and letting the exchange rate float freely so that monetary policy can then be directed to inflation control. Exchange rate should matter only if it affects domestic inflation. In theory, the recommended approach is either free float or a currency board.

In reality, however, the policy adopted by most central banks is different. A recent study by the IMF shows that most countries have adopted intermediate regimes of various types including fixed peg, crawling pegs, fixed rates within bands, managed floats with no pre-announced path, and independent floats with foreign exchange intervention moderating the rate of change and preventing undue fluctuations. By and large, countries have "managed" floats or central banks intervene periodically. Irrespective of the pure theoretical position of a currency board or a free float, the external value of the currency remains of concern to most countries and central banks.

Part of the reason for concern with exchange rates is also real, as seen in East Asia, Russia and elsewhere. The contagion effect is quick and a sharp change in the currency value can affect the real economy. Exporters may suffer if there is unanticipated sharp appreciation and debtors or other corporates may be affected badly if there is a sharp depreciation, which can also lead to bank failures and bankruptcies.

A fundamental change is the importance of capital flows in determining exchange rate movements as against trade deficits and economic growth, important in the old days. The latter do matter, but only over a period of time. Capital flows are primary determinants of exchange rate movements on a day to day basis. For example, the US with the largest trade deficit in the world has the strongest currency. Europe, with a massive trade surplus, has one of the weakest currencies. This result is explained by movements in capital flows.

Capital flows in "gross" terms which affect exchange rate can be several times higher than "net" flows on any day - and these are more sensitive to what everybody else is saying or doing than is the case with foreign trade or economic growth. Therefore, herding becomes unavoidable and then central banks have to intervene.

India has a "managed" floating with no fixed rate target. Daily movements are watched by the Reserve Bank very closely. Our markets are relatively thin, and the declared policy of the Reserve Bank is to meet temporary demand-supply imbalances which arise from time to time. The objective is to keep market movements orderly and ensure that there is no liquidity problem or rumour or panic-induced volatility.

There has also been a shift in the theoretical position on the "unholy" trinity of CAC, monetary independence and exchange rate stability. Some well known economists now favour temporarily or permanently giving up the CAC.

Others favour intermediate regimes.A second issue is that if some management of the exchange rate is required, what should we be monitoring - nominal or the real effective exchange rate (Reer)? From a competitive point of view and in the medium-term perspective, the Reer should be monitored as it reflects changes in the external value of a currency in relation to its trading partners in real terms. However, it is no good for monitoring short-term and day-to-day movements as "nominal" rates are sensitive to capital flows and also attract the most headlines. In the short-run, there is no option but to monitor nominal rate.

Another interesting issue is "stability" versus "volatility" in exchange markets. In principle, it would be desirable if exchange rates appreciate when capital flows are strong, and depreciate when they are weak.

Unfortunately, this option is not always available to central banks during periods of turbulence. There is a greater tendency to hold long positions in foreign currencies and hold back sales when news is bad and currencies are depreciating, than when news is good and currencies are appreciating. Also, corporates, investors, and FIIs prefer relative stability as hedging costs less when conditions are stable.

Another issue in the current debate on forex management is the appropriate policy for management of foreign exchange reserves. In a regime of free float, it can be argued that there is really no need for reserves. Some countries, where monetary policy is directed towards the single objective of inflation control, in fact maintain no reserves, except for operational purposes. However, in the light of volatility induced by capital flows and the self-fulfilling expectations this can generate, there is a growing consensus for emerging market countries to maintain "adequate" reserves. How adequacy is to be defined is still an open question. It is felt that reserves should also be adequate to cover likely variations in capital flows. The "Guidotti rule", mentioned by Alan Greenspan, argues that reserves should be adequate to cover one year's import and capital flow requirements.

In India, we are taking into account liquidity as well as import requirements and unforeseen contingencies. Reserves are now more than adequate to meet the oil burden and any other likely variations in capital flows for a fairly long period. We have followed a very careful policy to reduce our short-term debt, and also to ensure that relatively short-term deposits from NRIs, which are kept in FCNRB accounts, are matched by foreign assets of deposit-taking banks.

This is an edited excerpt from the RBI Governor`s inaugural address to the 21st Asia-Pacific Congress

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