FX International Payments
By Frances Coppola
Since March 2016, the exchange rate of the Indian rupee (INR) versus U.S. dollar has been rising, reversing the downwards trend in 2015. This comes as some relief to the Reserve Bank of India (RBI), which over the last year has come in for significant criticism in Indian political circles for maintaining high interest rates to control inflation partly caused by the rupee’s depreciation.1
Inflation in India is currently around 5 percent, though only a few years ago it was in double digits. As the RBI explains in its April 2016 bulletin, the USD-INR exchange rate influences inflation2:
“A 5 per cent depreciation relative to the baseline assumption could lead to inflation turning up by 0.1-0.15 percent above the baseline forecast for 2016-17.”
But it also influences growth. The RBI estimates that the same depreciation would raise growth by 0.05-0.1 percent. India’s Prime Minister, Narendra Modi, wants India’s growth rate to rise, hoping that as China slows,3 India will take over as the engine of growth in the East.4 The RBI’s anti-inflationary interest rate policy is seen as interfering with this ambition.
The RBI ascribes changes in the rupee’s exchange rate primarily to external forces. It says that depreciation of 2015 was due to the rising US dollar. Further depreciation in the first quarter of 2015 was due to investor flight back to “safe havens” as dismal Chinese data sparked sell-offs in emerging markets: exchange rates of other emerging market currencies such as the Malaysian ringgit and the Korean won fell even more than the rupee. In March 2016, the Bank of Japan’s announcement of further monetary easing calmed down investor fears and funds flowed back into emerging markets, causing emerging market currency exchange rates to rise. RBI policy had little, if any, external effect.
The RBI’s view of its own influence seems rather downbeat. India is one of the largest emerging market economies, with a GDP close to 2 trillion in US dollars. Policy-wise, it is a success story: it is currently growing at a rate of 7.6 percent, inflation is under control, its current account deficit has narrowed to 1.8 percent of GDP and it has strong stable foreign direct investment flows.5 The RBI’s Governor, Raghuram Rajan, is a former Chief Economist of the IMF and one of the few people who predicted the 2007-8 financial crisis. His views carry international weight.
And so do the policy decisions of the central bank he runs. The rupee’s exchange rate is by no means determined entirely by the tug-of-war between Western central banks. The RBI’s own policies have some effect too. For example, when the RBI cut interest rates at the beginning of in April 2016, the rupee’s exchange rate briefly fell.6
Nonetheless, the policies of the “big five” central banks – the Federal Reserve (Fed), European Central Bank (BoE), Bank of Japan (BoJ), People’s Bank of China (PBOC) and Bank of England (BoE) – can have “spillover” effects in other parts of the world. Their monetary interventions since the 2008 financial crisis are thought to have caused currency exchange rate volatility and market turbulence far beyond their borders.7
Dr. Rajan believes that these powerful central banks should pay more attention to the external effects of their policies. Calling for a new era of cooperation among central banks, Dr. Rajan has outlined a framework for a global managed exchange rate system akin to the Bretton Woods system of 1946-71.8
Dr. Rajan’s forthright views have ruffled political feathers in India. Not so much for his comments on global monetary policy, or even his recent description of “risk-on, risk-off” behaviour among investors as “manic depressive”,9 but for his opinions on domestic policy. Sadanand Dhume of the American Enterprise Institute wonders whether Prime Minister Modi will reappoint him when his three-year term of office ends this year. Mr. Modi may opt for someone easier to manage.10
But if there is one thing that Dr. Rajan demonstrates, it is independence. And in a world where markets look to central banks for guidance, and remarks by central bank governors move markets, central bank independence is a prized commodity.
Greater stability of currency exchange rates could be beneficial not just for India but for the global economy. Wild swings make international trading conditions difficult, and can cause headaches for policymakers as exchange rate changes feed through into domestic prices. More cooperation among central banks might help to calm things down. But central banks can only do so much.11 In the end, it is up to investors to look to the longer term and ride out the storms of today.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
9. Speech “Towards rules of the monetary game” in RBI April 2016 bulletin, op.cit.