Indian Economic Thought and Exchange Rate Management
In the post-Independence era, Indian economic thought largely supported state-managed price controls on necessary commodities such as steel, cement, electricity, and wheat, considering it essential for economic stability. However, over time, the understanding evolved that allowing prices to fluctuate can be more beneficial for economic growth.
Challenges of Managing Exchange Rates
Similar to price controls, the management of the dollar/rupee exchange rate presents immediate benefits but also significant hidden costs affecting fiscal health, macroeconomic stability, state capability, and private sector behavior.
- Fiscal Costs:
- Central bank intervention in currency markets can lead to fiscal expenses borne by the Ministry of Finance.
- The "Market Stabilisation Scheme" previously imposed interest costs directly on the exchequer.
- Borrowing through foreign currency non-resident deposits supports the rupee but incurs fiscal costs.
- If the exchange rate shifts, it can lead to significant financial burdens due to reduced dividends from the Reserve Bank of India.
- Macroeconomic Stability:
- The RBI's mandate is to maintain an inflation rate of 4%.
- Exchange-rate management conflicts with inflation targeting, leading to instability.
- Deviating from inflation targets induces macroeconomic instability, which is a cost of controlling exchange rates.
- Accountability:
- Effective state capability requires clear accountability.
- Having dual objectives like inflation targeting and exchange-rate management dilutes accountability.
- Failures in one area can be attributed to the demands of the other, hindering accountability.
- Institutional Credibility:
- Credibility is crucial for state trustworthiness.
- A central bank that frequently intervenes in exchange rates loses credibility and respect over time.
- Policy inconsistency, like altering announced policies, affects future policy credibility.
- Impact on Financial System:
- The financial system needs to manage time, risk, and resource allocation efficiently.
- Central bank's exchange rate management impairs market development and liquidity.
- Capital controls negatively affect the cost of capital and the financial system's problem-solving ability.
- Private Sector Challenges:
- The controlled exchange rate environment complicates risk management.
- Periods of stability followed by abrupt changes make currency hedging difficult.
- Firms face volatility that is artificially suppressed and then suddenly released.
- Moral Hazard:
- State-provided currency risk management encourages firms to take unhedged foreign-exchange risks.
- This behavior increases systemic risk and leads to inefficient use of private sector resources.
Conclusion
Transitioning away from price controls marked a significant milestone in Indian economic history. Similarly, the management of the dollar/rupee exchange rate demands maturity and understanding of its broader economic implications. India's growth strategy should focus on developing a modern financial system, improving state accountability, and encouraging private sector innovation.
