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No solution for FX travails
The RBI still does not anchor its FX market policy to a larger economic objective. Ad hocism reigns supreme.
IN A RECENT speech at the IMF, RBI Governor Subbarao passed up an opportunity to explain India’s policies on FX market intervention and their holding of FX reserves.  One expected him to identify at least some criteria to answer some of those questions.

For instance, the RBI could have identified a larger economic objective – say an inflation target or some real quantities (unemployment or GDP growth) – which would guide its market operations. Like Swiss National Bank (SNB), whose recent FX market interventions, the Governor seemed to be alluding to in his speech, has resolved to prevent the Euro/Swiss Franc exchange rate falling below 1.20. That stance on intervention is driven by the SNB’s objective of preventing de-growth and deflation in its home country.

The Governor did not identify such economic goal-posts as driving RBI’s FX market intervention.

Ad hoc and unstructured…

So, what we will continue to have in India is FX policy on the go. Policy-makers will continue to react in an unstructured manner to market developments. In that environment, FX market intervention and the holding of FX reserves become ends in themselves.  The Governor seemed to be saying as much when he indicated that FX market intervention to defend the local currency during a phase of depreciation, despite holding FX reserves, may not be a workable proposition. As for preventing local currency appreciation, the Governor frankly admitted  that there was no limit to such intervention as countries can print their own currency at will. India did much the same in the last decade and accumulated $ 300 billion of reserves in the process and triggering out-sized asset price inflation and overall inflation pressures.

India’s corporate sector can testify to that arbitrary approach of the RBI. Indeed, one wishes India’s corporate sector, at least now, after the significant disorderliness they have weathered in the FX markets in the past couple of years, realises that and institutes structured financial risk management practices.

Massive FX losses on company balance sheets...

Scores of companies which took on FX liabilities on a base of Rs.45 to the dollar were compelled to reckon with a new base some 25 per cent lower. We have since needed repeated amendments to the accounting standards to disguise those massive FX losses on company balance sheets.  

That recommendation on disciplined risk management would be even more relevant for India’s vast unlisted corporate sector, comprising thousands of small companies with significant FX exposures and who suffer from notable information and knowledge gaps.

For long, India’s corporate sector seemed to be relying on the RBI’s repeated promises of ensuring orderliness, stable conditions and controlled volatility in the FX markets. For instance, the RBI used to always preface its messages about FX reserves thus: “that the reserves are being held as an insurance against disorderly market conditions, to reduce volatility, to meet liquidity needs for essential imports and to ward off speculative attacks…”  Many  in the corporate sector took on large FX exposures and literally out-sourced risk management to the RBI.   

2007 was a harbinger

The risks in such outsourcing of risk management to a central bank which did not have a structured policy framework were made very clear even in 2007.  

The RBI, in that period, withdrew from large-scale FX market intervention all of a sudden, resulting in a steep appreciation of the rupee. The prospect of more such appreciation then became one of the critical drivers of complex, large-scale derivatives transactions in our FX markets ‘ostensibly’ designed to protect companies from such appreciation.  

Unfortunately, once the rupee reversed direction in due course, the entire complex of those derivatives transactions generated large losses for the corporate buyers. The resultant court cases are still being fought, with not much hope for the companies. Some small and mid-sized companies even had their net worth wiped out by the losses.   
Despite such a chequered history of the rupee exchange rate and of the RBI’s FX market intervention practices, it is striking that the RBI still does not anchor its FX market policy to some larger economic objective. Ad hocism reigns supreme.
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