Understanding India’s Exchange Rate Regime

India does not have a freely floating Rupee, which is to say, our exchange rate is determined heavily by the actions of the Reserve Bank of India (RBI), which is our Central Bank, and not solely by the market. We take a look at some of the concepts and recent concerns and share some material of interest.

Figure 1: Argentine Sovereign Default 2002

In the absense of central bank interventions, the exchange rate is determined by fundamental factors. However, almost every country, or perhaps all of them attempt to manage the exchange rates of their currencies, in different magnitudes, for various reasons. The wikipedia article on currency regimes explains just how wild it can get – not only are there numerous exchange rate regimes (fixed, peg, managed float, free float), there are various sophisticated ways to manipulate this rate. Central banks today have an array of weapons to influence the exchange rate.

However, in practice, there are severe limitations to this intervention. Additionally, currency manipulation can lead to disastrous consequences. Figure 1 shows the Argentinian Financial Crisis of 2002 (please read the linked article) which led to sovereign debt default. To put it simply, trying to artifically fix exchange rate above the one determined the market causes Forex reserves to be depleted pretty fast, leading to sovereign debt default and eventual catastrophic devaluation of currency. Notice the flat line depicting 1-for-1 exchange between Peso-Dollar until the crisis after which the Peso is devalued.

Exactly the opposite case is that of China, which keeps its currency artificially low by buying dollars. China seems to have no trouble at all.

In other words, and this is very interesting – keeping your exchange rate low can be long-term sustainable, while keeping it high is not. It is easy to understand why this happens: Exchange rate is determined by relative demand for your currency. If you want to keep your currency artificially high, you have to sell Forex reserves in order to artificially create shortage of your currency. Clearly unless you have an unlimited supply of foreign reserves, this is impossible to achieve.

On the other hand, China for instance, enabled by their strong economic growth can afford to keep buying foreign currency. This creates an artificial demand differential between the Renminbi and Dollar – causing the former to get a lower exchange rate than it would have otherwise got.

It is instructive to review the various financial crisis that have hit specifically the Asian and Latin American countries in the 80s and 90s. Since then, most countries have gotten smarter about not trying to monkey around with the exchange rate too much, specifically on the up side, not borrow too much in foreign currency denominated debt or rather not borrow too much, not print money etc. The current financial crisis mainly stems from structural reasons and not exchange rate interventions.

India’s Exchange Rate Regime:

Q: Finally, the rupee, it has been the underperformer in the Asian basket, at least in the past few months, that’s because of a broadening trade deficit. Any views on what the trajectory might be, is the bad days over or do you think that there is more appreciation for the rest of 2010?

A: We actually think structurally the rupee is a bit overvalued. If you look at it on a real exchange rate basis and you pointed to the trade deficit, we point to the large current account deficit currently being experienced by India, it suggests that the rupee is overvalued. So, in the longer term, we think that more depreciation is in stored for the rupee. (David Forrester, Vice President, Global FX Strategy, Barclays Cap, September 2010)

Some people tend to confuse forward looking analyst opinion with RBI intervention. When an analysts says for instance, the Re is overvalued, it does not mean RBI has artificially propped up the Re, merely the analyst thinks that based on the direction of fundamentals (GDP, trade balances, inflation etc.) the Re is likely to get devalued.

Sure enough, after this interview, the Re got devalued. From somewhere around 44 to now it stands at over 52, threatening to go down even further:

Figure 2: USD-INR Exchange Rate 

Why is our exchange rate going South? Weakening fundamentals, lower than expected growth coupled with FDI drying up is causing this problem. 

Now, let us hear from the RBI itself, the presumed villain:

Figure 3: History of Rupee Dollar exchange rate

There is a beautiful article on the RBI website, Exchange Rate Policy and Modelling in India which explains how India’s exchange rate regime changed over time. India claims to have introduced a market determined exchange rate in March ’93. In part, this reform came about after our financial crisis of 1990-91. 

RBI’s own stated objective is as follows:

In this context, it is important to recognize that the Indian approach in recent years has been guided by the broad principles of careful monitoring and management of exchange rates with flexibility, without a fixed target or a pre-announced target or a band, coupled with the ability to intervene if and when necessary, while allowing the underlying demand and supply conditions to determine the exchange rate movements over a period in an orderly way.

Since we can not take RBI at face value, we explore further.

Several Indian economists perform sophisticated research on the topic. Here is an extract from a paper
by well known economists Ila Patnaik, Ajay Shah et all – The exchange rate regime in Asia: From Crisis to Crisis May 2010):

The de jure exchange regime for the Indian rupee is that of a managed float since 1994. However, regression results for India suggest that there has been a cycle of inflexibility and greater flexibility, with very distinct breaks in the exchange rate regime. There was a long period of peg to the USD with an R2 of 0.84 till January 1994. The rupee value went back to a hard peg to the USD, taking the R2 of 1 till February 1995. Since then there has been greater flexibility in the rupee with both the beta coefficient on the USD and the Euro being significant.The rupee appears to have moved to a basket peg since April 2004 and on 23 March 2007, a further move towards flexibility came about. There are substantial differences between this history of the exchange rate regime, when compared with official statements and  dates.

Yet another paper Is The Rupee Overvalued? (Feb, 2010) by Mathew Joseph and Karan Singh examines the Real vs. Nominal effective exchange rates:

In 2004-05, India’s current account was nearly in balance with a current account deficit of just 0.4 per cent of GDP. We can say that the rupee was in equilibrium that year. After touching a peak in 2007-08, the REER fell during the crisis period in 2008-09. However, it has been moving up again since March 2009. By November 2009, it had broken the equilibrium value and become overvalued to the extent of about 9 per cent. The REER computed using India’s WPI is a gross underestimate and wrongly gives the impression of an undervaluation of the rupee.

How do industrialists view our currency regime? They prefer the Re to be pegged to the dollar since it eliminates exchange rate risk. They also like an undervalued currency since it makes them more export competitive. Here is T.B. Kapali, Vice President (Economic Research) of Sriram Group in an op/ed: 

A pegged rupee though seems an unrealistic expectation. Though there is a long history of the RBI actively managing the rupee (and also generally preferring a weak rupee), a de jure peg could be a different ball game for which the Government and the RBI may not be prepared. (We have said de jure here since the official policy of “managing the impossible trinity” goes some way in creating a de facto pegging regime in India).

A managed rupee exchange rate regime with a fair degree of volatile movements seems set to continue for the foreseeable future. In this world, we will see the RBI continuing to actively manage the rupee and slow down its structural appreciation — that is, allow only controlled appreciation.

To summarize: India has a de jure managed float exchange rate regime that has moved towards greater flexibility in recent years. To researchers, the regime appears to be de facto peg to the dollar since our largest trading partner is the US. However, India has moved to a basket of currency recently for its reference rate.

The exchange rate is managed within a narrow band but never deviating much from the market driven rate. The Re does get overvalued / undervalued for short time windows but but only by a small magnitude. There is a possible bias towards undervaluation. The main reason for managing the exchange rate by the RBI is to contain volatility which is caused by wild fluctuations in macro economic environment, wild swings in FDI – typical for a developing economy. Needless to say these things are under constant watch by academics, corporate houses, financial institutions and not the least – India’s trading partners.

Any abnormal manipulation is likely to be called out immediately. There are a few concerns about the exchange rate regime and lack of RBI transparency in their interventions, particularly moral hazard involving exchange rate guarantees and hedging facilities to corporates. 

 

What is the ideal exchange rate?

The prevailing wisdom for developing countries is to keep the currency undervalued since it allows them to gain export competitiveness. China currently does it, Japan, Korea all have followed this regime. However, this is questionable. 

Let us understand the implications of keeping the currency undervalued. Suppose you produce components for an export oriented firm. All your revenues come from domestic sources. The export oriented firm gets the major portion of revenues from abroad. The undervaluation will give you a lower revenue in local currency than you would have otherwise gotten. Now, if you have to import that machinery from Japan, you will spend more money than you should have. For the export oriented firm though, this is a great situation – they spend relatively less in costs at home, while getting more value for their dollar profits earned from aborad.

Ergo, an undervalued currency favors those who earn in dollars and spend in Re. 

Clearly, the deliberate policy of undervaluation transfers wealth from one group of individual to another. The excuse given usually is, we create more export oriented jobs. Is that the reality for India? Are we really generating export oriented jobs? Our trade balances are deeply negative. We are nowhere near creating the kind of manufacturing jobs that say China is. 

Additionally, an undervaluation eventually passes the cost to the poorest segment of the population. The net gainers are corporates and their rich employees. The poor pay with reduced standard of living. 

In addition to this, undervalued currency causes structural long-term deficiencies in the economy that can be fatally harmful. Companies tend to try and export every which way they can of less value added goods. Their investment pattern shifts. While undervaluation makes one set of companies more viable (Revenue in $, COGS in Re), it makes another set unviable.

A completely market driven currency, aside from being long-term efficient is also the most moral solution. 

 

References:

 

http://rbidocs.rbi.org.in/rdocs/PressRelease/PDFs/IEPR1716R0412.pdf 
http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=15 
http://macrofinance.nipfp.org.in/PDF/PS2007_sl_01_currency_regime.pdf 
http://intl.econ.cuhk.edu.hk/exchange_rate_regime/index.php?cid=15 
http://www.nipfp.org.in/working_paper/wp_2010_69.pdf 
http://www.icrier.org/macro/12feb10.html 

Big Mac:

http://www.thehindubusinessline.com/industry-and-economy/banking/article28082…

“Bit overvalued”

http://www.moneycontrol.com/news/rupee/rupee-looks-overvalued-says-barclays-c…

RBI says Rupee overvalued:

http://www.business-standard.com/india/news/re-overvalued-76-says-rbi/229257/&n
bsp;

“generally preferring a weak rupee”

http://www.thehindubusinessline.com/todays-paper/tp-opinion/article994362.ece…

http://eaces.liuc.it/18242979200901/182429792009060108.pdf 

RBI speech:

http://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=288 

More recent RBI (from the horses own mouth)

http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12252#CON 
http://www.rbi.org.in/scripts/PublicationsView.aspx?id=12252#EXC 

Argentinian currency crisis:

http://theinflationist.com/sovereign-default/argentine-sovereign-default-2002…

China:

http://money.cnn.com/2010/11/10/news/economy/what_is_currency_manipulation/in…

 

 

 

 

 

 

 

The real scam in Gujarat

Much has been made out about a recent CAG report on PSU performance in Gujarat. However, closer scrutiny reveals that much of it is media histrionics and the usual embellishments that tend to surround every report out of the state. 

On 19th April, Gujarat chief minister Narendra Modi will dedicate the Charanka Solar Park to the nation. This event will attract praise from even the chief minister’s biggest detractors. This is ironical, because if there is one state policy that deserves a sound walloping, it is the state’s Solar energy policy.

Although more or less proven to be a hoax, Global Warming (aka Climate Change) still remains the top polarizing policy debate among the chatterati classes. It is also one of the topics the most ardent devotees of this voodo science are least informed about. Most people believe, for instance, “fixing” Global Warming will actually reduce the everyday pollution they experience – dust, poisonous fumes from vehicles, eroded top soil, urban heat island effect etc.  Most people are also not very familiar with what the “fixing” of Global Warming entails, or what they really do when they conggregate at one of those climate conferences that happen every now and then.

Simply put, the prescribed “fixing” of the “problem” formerly known as Anthropological Global Warming (AGW)  and now refered to as Climate Change involves reducing emission of CO2 generated by human activity, such as a coal based power plant. However, very little attention is paid to the actual mechanism, feasibility or even effectiveness of the measures suggested. 

Before you proceed:  Please read this analysis by Christpher Monckton.

For obvious reasons, we will not attempt to debate the theory of Global Warming but demonstrate that the deeply flawed and misconceived Solar Energy Policy of the state will rob taxpayers out of billions of dollars, while providing practically no reduction in CO2 emissions – and introducing a whole slew of negative externalities along the way.

The Cost:

The state’s own public documents show that the state intends to purchase electricity from Solar Energy providers (photovoltaic) at the rate of Rs. 12.00/13.00 per unit (kWh) for the first 12 years and at Rs. 3.00 thereafter. This clearly implies a subsidy of about Rs. 9.00 per unit. The state wants to have  a maximum of 500 MW installed capacity for the period up to 2014. Assuming peak planned installed capacity and peak output throughout the year, round the clock, the annual subsidy works out to be:

                      500 MW x 1000 kW/MW x 24 x 365 x Rs. 9

This equals about $800 million per year. This is a devastatingly high number to spend every year for 12 years for just 500 MW of electrical power. Of course, solar power is not available throughout the day (except for Solar Thermal type projects). So, the cost is likely to be less. The impact to state exchequer could be further reduced by central subsidies and international grants. 

By contrast the effective cost for conventional energy sources (coal, gas etc.) works out to be between Rs. 1.50 – Rs. 4.00 per unit. 

Also check out the initial investments and capcity expansion plans here.

 

Negative Externalities:

Solar companies claim the life of photovoltaic cells to be up to 40 years. This remains to be seen, in the local conditions. There appears to be no strategy for disposal of highly toxic waste material from discarded solar cells. Once again, the cleanup cost is not factored in. Perhaps a future Govt will have to deal with it.

Photovoltaic power plants will also use very large quantities of fallow land – that could be used for other purposes. 

The emphasis on Solar energy means a distraction from finding better sources of energy, such as wind or hydro. Both of these are far more viable in India, especially hydro electric. Hydroelectric provides about 16% of our national energy output. 

 

The Futility of it all:

Of all the so called Renewable Energy Sources (RES), Solar energy is definitely the worst. Yet, Global Warming scare mongers seem to prefer Solar energy for some reason. It sounds sexy and high tech but is in reality, neither. Unless a miracle in fundamental physics occurs, Solar Energy is not going to become much more viable in the near future. 

Now, let’s see how Gujarat’s Solar Energy Plan measures up to the goal of reducing CO2 emissions. Remember that our original goal (though misplaced) was to reduce CO2 emissions. 

Gujarat’s current installed total energy capacity is about 18,000 MW. Even assuming peak output round the clock at all times and 100% capacity utilization, the total Solar component of it is going to be less than 3% up to 2014. Beyond that, even conventional units will come up to meet energy demands, Solar will play catch up, realistically never exceeding about 5% of total energy output. Even assuming the rest of the 95% comes from purely carbon based sources (much of it will be ,  non-CO2 – such as Hydro/Nuclear etc.) in effect, the ambitious, much praised and discussed pioneering Solar Energy plan of Gujarat is going to cut CO2 emissions by a total of 5%. Now, power plants are not the only CO2 emitters – so, when we add up the total CO2 emissions of the state, the mitigation provided by Solar Parks is negligible and an exercise in futility.

Now, the hardest part. One of the least unerstood aspect of Solar energy is how it plays out in the total energy mix. Given that Solar energy is available for part of the day, grid integration often involves increasing the idle capacity of conventional energy sources. It is easy to understand it using an example. Let’s say you intend to produce 20% of your electicity from Photovoltaic cells and the rest from Coal fired power plants. Now, this 20% capacity is not available at night. So, you have to actually install 100% of coal capacity plus the additional solar capacity (peak power requirement at night is often lower, so it reduces the problem, but it will still exist). This increases the cost of conventional energy. Even worse, since conventional power plants emit substantial amount of CO2 even when idle (boilers need to be kept going etc.), the theoretical mitigation provided by Solar power is reduced even further.

If CO2 emissions for manufacturing the photovoltaic cells is factored in, the CO2 balance might as well turn out to be in the negative territory. 

In other words, we are trying to save pennies on the dollar in terms of CO2 emission reduction (if that), at a cost of billions of dollars.

Meanwhile, Gujarat sells electricity to industrial units at one of the highest prices in the country, at around Rs. 7 per unit. There is enough evidence that this is causing an impact
on small scale industries. 

 

To summarize, the Gujarat Solar Energy policy is based on voodoo science, it attempts to fix a non-problem with an even more ridiculous solution. Ironically, this is one aspect of the state policy that gets loads of press and praise. 

Does organized retail make sense?

This post is a general discussion in the backdrop of the Govt’s recent decision to permit up to 51% FDI in multi-brand organized retail, a move that has since been suspended due to the furore it created.

NOTE: Please read like you are doing a hypothetical exercise. Do not let assumptions, realpolitic, standard of living, wage inequality crowd your thought process – we will address them or rather explain why we won’t address them subsequently.

What makes a country rich? The only reasonable and succinct answer to this question is – its citizens consume more. They just buy a lot of stuff – food, clothes, services, health insurance, facelift, cars, cruise trips. Given that a country’s population is constant (point in time, population growth is not relevant to this discussion), what will make it richer? The answer is obvious, if it can get (produce or buy from other countries) more stuff. 

How will you produce more stuff? One answer is to employ more people. But this is problematic, since if everyone produces boxes, there will be no one left to produce balls. So, you will have a loads more boxes than you know what to do with and no balls. The obvious answer is to increase efficiency. 

How do you get more stuff from other countries? In that case, you have to be able to pay more to China. In order to be able to pay more to China and get more boxes, you need to produce more balls  which you can sell to other countries. You will require surplus ball production.

Therefore, no matter how you cut it, the key challenge is to be able to produce more stuff with less people. You need to make your sectors more productive. 

There are two ways a secor can become more productive – (1) it can elect to produce more while employing the same number of people, (2) it can elect to produce the same amount of stuff while laying off some workers. Ergo, you either change the numerator or the denominator in the productivity equation.

Now we got a problem. Supposing we want to make the box sector more productive, by introducing say a Sumo Box Making machine from Japan, workers in the box sector are immediately threatened. There is no debating it. How do you get around this issue? The ball sector meanwhile can hire more workers. You make balls at the best cost in the world. So, you will move the surplus employees from the box to ball production. It is a no brainer, since your ball has the best cost structure, you will sell to other countries and you are in business.

It gets better. Now that you have the Sumo Box Making Machine, you are actually making boxes at a very good price structure. Now you are selling loads of boxes to other countries as well. Suddenly, the box makers can get more boxes and more balls. Likewise for the ball makers. As a bonus, they sell both products outside in exchange for spirals.  Your country is much richer than before because now everyone has more boxes, balls and spirals.

In other words, key to making a country richer lies in moving workers from unproductive sectors to productive sectors. 

Now, let us understand this in the context of retail. If you have a fragmented retail market,  many middlement, for the same amount of goods you are in effect employing more people. Consolidation and reduction of middle layers will obviously increase the net productivity of manufacturing boxes and delivering them to consumers. Clearly, organized retail makes sense. Most countries have a mix of organized large retail chains and also a large number of small and medium specialty retail shops. 

Therefore, the key issue is not whether organized retail makes sense, – it obviously does, but how to create the consensus to be able to achieve it.  

Socialism …

Does capitalism lead to corruption?

As the ruling UPA dispensation becomes increasingly mired in various scams and scandals, it is now a common refrain of intellectuals to blame the ‘capitalistic’ system for increased corruption in society. Recently P. Sainath, in an opinion piece for The Hindu, put the blame squarely on ‘neo-liberal economic framework’ . Mani Shankar Aiyer echoed these thoughts in a Times Now TV segment.

We decided to look at data. 

How does one measure ‘capitalism’? Fortunately, the US based think tank The Heritage Foundation publishes an annual report on index of economic freedom in collaboration with The Wall Street Journal. This index can be used as a proxy for capitalism. Corruption data is also easily available in the form of the widely known index published by Transparency International. The chart above is a result of plotting the corruption perceptions index (higher value means more transparency and hence less corrupt) against the index of economic freedom. 

What we see here is a beautiful representation of cold hard facts that blows the socialist propaganda to smithereens. The freer a country in terms of economic freedom (i.e. the more ‘capitalistic’ a country is), the less corrupt it happens to be. 

India (economic freedom=54.6, corruption perceptions index=3.3) happens to be smack on the trendline.

There are a few more interesting things that stand out in the chart. It looks like the less capitalistic countries are actually doing even worse than trend in terms of corruption – see these clustered below the line. There is also an inflexion point of sorts, it happens at around an economic freedom index value of about 70. Above this value, the countries are able to beat the trend and even match the least corrupt countries. So, which are these countries? Some of them are South Korea, Japan, Taiwan, Belgium, Sweden etc. 

 

References:

Transparency International – Corruption Perceptions Index 2010
Heritage Foundation – The 2011 Index of Economic Freedom

More on Human Development Index

Some more random thoughts in continuation to the previous post.

Here are two charts that plot the UN Human Development Index values against the per capita GDP of the respective countries.

The first chart represents almost the entire universe (data not available for some countries). As expected, HDI sharply rises as per capita GDP rises and then levels off. India ((HDI Rank: 119, Index: 0.519, per capita GDP US $1,017) has to go a long way even to catch up with medium developed countries. If we take the inflexion point of the graph, which seems to occur at the $10,000 mark, we need to be at least $10 trillion in GDP, before our HDI can start to look respectable. This is a sobering thought. There is no way to really bypass this reality. 

The second chart represents some countries close to India’s per capita GDP. Even within our limited scope, how are we doing? The trendline can be thought of a measure of how efficiently you are spending your GDP to achieve Human Development. If you are above the trendline, you are doing better than your cohorts. If you are below, your policies are sub-optimal. The best performer in this range is Uzbekistan, the worst – Sudan (data will change from next year, one presumes). India is certainly doing better than some of its cohorts, but our policies are not really generating extra Human Development outside of trend. This can be a measure of policy effectiveness. 

 

Understanding Conspiracy theories

Why do people spin conspiracy theories? Why do people believe in them? Obviously the subject is quite complex – the wikipedia entry is actually a pretty good resource. 

As a neighboring country to Pakistan, where reason seems to have been wholly substituted with conspiracy theories, we are no strangers to these things. Does not mean that we do not spin conspiracy theories ourselves.

In the Indian political scene, we see the predominance of a certain class of conspiracy theories. This is actually a direct fallout of “activist” journalism – as practiced by magazines such as Tehelka.

Two good examples are the 26/11 conspiracy theory and the current Binayak Sen case. In each of these cases, the spinners ignore the vast and often overwhelming body of evidence and obsessively focus on a relatively minor unexplained item. In the first case for example, we saw conflicting reports about the jacket worn by Mumbai ATS top cop Hemant Karkare. 

The allegedly missing jacket does not wipe out some thousands of eye witnesses, cctv footages, 9 dead terrorists and a live one – among other things. The fallacy is quite obvious.

In the Binayak Sen case, predictably his sympathizers are constantly focussing on a few faux pas committed by the prosecution. Arguably these mistakes should result in a motion of mistrial. Unfortunately that would probably mean dismissal of most cases in Indian courts. Judges are aware of this and that is why those items were struck off and prosecution side pulled up and chided by the judge in no uncertain terms.

#NoGov Belgians doing just fine without a Government …

Understanding the revolutions: A comparison of Human Development Indices of selected countries

Source: UN Human Development Report 2010

A change in narrative style – from Life-Story to Intellectual Endorsement

While we have not yet directly felt the tremors of the middle-east revolutions, events of possibly historic proportions are unfolding.We have had massive scandals involving all areas of public life, including the executive, legislature, judiciary and this got extended right down to the fourth estate. 

Meanwhile, there has been a silent but noticeable change in the narrative style. 

The earlier style was story centric – or should we say, life-story centric. This went something like this:

I was walking down the street, when I saw Monu. All of eleven years old, his clothes were threadbare and his skin parched. Yet, there was a swift air of efficiency about him, a calm confidence as he used his shoe brush to gently knock the footstand so that the gentleman, distracted by page 3 gosssip could please extend his other shoe … for Monu to polish. I thought to myself, there must be millions of kids like Monu who should really be in school but who are already having to duke it out with the elements. Why are we like this? Why do we only think progress is about glitzy shopping malls, rockets, spaceships and not about sending Monu to school? Every successive Government has let Monus of this country down. Now we have the RTE act, but it sounds like too little too late. Well, too late for Monu anyway. 

etc.

This was of course the social justice theme, there are many others. The template remains the same, like most Bollywood films. A little tweak of the script and et voila! You have a new story. The villains are well known, the hero of course is the writer, he has noticed Monu, unlike you heartless fool – see?

We notice that this is slowly changing. 

Now we have a dozen intellectuals at the ready to sign off on any Left-Lib cause (agenda). A physicist vouching for some sort of bill involving food grain distribution, a nobel laureate in literature endorsing an anti-corruption bill. In other words, the narrative style has changed from life-stoty to celebrity/intellectual endorsement.

Coming back to the revolutions again, perhaps it hasn’t happened because there has been no celebrity endorsement. Any ideas why?