And so it is with exchange rates. When the central bank controls the dollar/rupee exchange rate, there are immediate beneficiaries. Firms engaged in international trade receive subsidised currency-risk management. Exporters and importers experience artificial stability in their cash flows. There are also less visible costs, dispersed across the fiscal math, macroeconomic stability, state capability, and the behaviour of private firms.
1. The first category of costs is fiscal. When the central bank intervenes in the currency market, some costs are passed up to the Ministry of Finance. In the past, the “Market Stabilisation Scheme” directly imposed interest costs for the implementation of currency policy upon the exchequer. Borrowing through foreign currency non-resident (bank) deposits props up the rupee today, but it imposes fiscal costs. When the central bank supplies a currency hedge to banks, future losses on this hedge reduce the dividend paid to the government. If the dollar/rupee moves by ₹10 on a position of $50 billion, this induces a cost of half a trillion rupees to the seller of the financial derivative. The Ministry of Finance bears this cost through smaller dividends from the Reserve Bank of India (RBI).
2. Beyond the exchequer, there is a cost to macroeconomic stability. The legal mandate of the RBI is to deliver an inflation rate of 4 per cent. Exchange-rate management introduces a conflict of interest. The policy rate required to defend a specific currency level is often different from the policy rate required to achieve the inflation target. When the central bank prioritises the exchange rate, it departs from the inflation target. This induces instability in inflation. This elevated macroeconomic instability is the price the economy pays for price control on the exchange rate.
3. This connects to the problem of accountability. The path to state capability is paved with accountability. When an agency has two objectives, such as inflation targeting and exchange-rate management, accountability breaks down. It is then possible to blame the failure in one area on the necessities of the other. If the inflation rate deviates from the 4 per cent target, the agency points to the burdens of trading on the rupee-dollar market, and vice versa. The emergence of state capability in India requires agencies with a single objective and no place to hide. This would create the pressure of accountability.
4. There is the cost to institutional credibility. Credibility is the trust the market places in the state. A central bank that acts as a large trader in the market, attempting to force the exchange rate to a desired value, loses credibility. Policy statements are made and then violated in the dogfights with the market. Consider the premature closure of the FCNR(B) window. The central bank announced a closing date, but then altered it. Each such action reduces the currency of policy credibility. In the future, the market will believe policy announcements a little less. A clean inflation-targeting central bank, free from conflicts of interest, builds respect over the decades.
5. Finance is the brain of the economy. Economic growth requires a financial system that processes time and risk, and controls resource allocation. When the central bank runs a price-control system for the dollar/rupee, its use of powers in financial economic policy is attenuated through an ulterior motive to damage market development. To help maintain control over the currency, the state stunts the liquidity and efficiency of the bond-currency-derivatives nexus. The state runs a system of capital controls, which harms the cost of capital. These interventions restrict the ability of the financial system to solve problems in the real economy, and harm the project of Indian economic growth.
6. For the private sector, the non-market environment for the rupee creates a complex risk-management problem. There is a stop-start pattern. The dollar/rupee rate remains sleepy for long periods. This gives a false sense of calm. Inevitably, the sleepy period ends. A bout of big price changes follows. This environment makes business planning difficult. It is harder to execute currency hedging under these unexpected periods of turbulence and calm than it is under a pure market-exchange rate. The private person faces a volatile environment where the volatility is suppressed and then released in bursts.
7. This dynamic breeds moral hazard. When the state supplies free-currency risk management, firms take more unhedged foreign-exchange exposure. This builds up systemic risk. Parts of the private sector devote themselves to gathering intelligence about the target exchange rate, so as to extract value from the government’s price control. This is a poor use of the intellectual power of the private sector. Indian growth is maximised when firms devote themselves to customers, technology and management.
The transition away from some price controls was a milestone in Indian economic history. It was achieved by looking past narrow desires in price control, and understanding the consequences of price controls for Indian economic growth. The management of the dollar/rupee exchange rate requires the same maturity. The costs encompass fiscal burdens, inflation volatility, stunted financial markets, systemic risk, and degraded state capability. Exchange-rate policy is not a narrow concern of monetary-policy strategy. It is a fundamental choice about the broader economic-growth strategy. India requires a modern financial system, a capable state with high accountability, and a private sector focused on innovation rather than government arbitrage. The path to Indian economic success begins with a full reckoning of the costs of exchange-rate management.
The author is a researcher at XKDR Forum
