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Thursday, December 15, 2011

RBI reaches for capital controls

By and large, I have felt that RBI has done a pretty good job of the exchange rate. They doubled currency flexibility twice, in 2004 and 2007. In 2009, they shifted to a floating rate. There were two problems:

  1. They continue to sometimes do tiny blocks of trading on the currency market. In a market of $70 billion a day, a small scale of trading (e.g. $1 billion a month) is irrelevant, so why bother doing it? This has been pointless, but it has done no damage.
  2. They have failed to correctly communicate to the market that the exchange rate is now a float. I cannot recall an RBI governor who used the phase "floating exchange rate". Many economic agents seem to have got the following message: You're on your own for small fluctuations, but if there are big movements, RBI will block them. This was mis-communication. The people who hedged against small movements but not against large ones, as a consequence of RBI, have now got burned. This is going to further increase the cost of RBI to gain credibility in the years to come, to come to a point where its words are respected.
Barring these two issues, I have felt that RBI has done a pretty good job of the exchange rate. Until now.

RBI has just announced a batch of capital controls against the currency market. This is a mistake:
  1. When there is turbulence on the currency market, you want greater activity on the currency derivatives market - which is where people protect themselves from currency risk - not less. Recall how the Greek default really damaged the Italians because on that day, the owner of an Italian government bond was told that maybe his CDS would malfunction if an Italian default came about. It was not good for Italy for economic agents to have a reduced ability to manage this risk.
  2. This will merely shift business to alternative venues - the offshore market and the onshore currency futures market. To the extent that shifting to these venues is tedious or infeasible (e.g. FIIs are banned from the onshore currency futures market and don't have that choice), economic agents will be averse to holding India risk. This is bad for asset prices in India at a particularly difficult time.
  3. In a climate of pessimism about economic policy, it is important to send out a message, through action and non-action every day, that RBI (and more generally the Indian economic policy establishment) possesses top quality knowledge and decision-capabilities in economics and finance. This action of RBI reinforces the gloom about economic policy capabilities in India.
In April, Ila Patnaik and I released a paper titled Did the Indian capital controls work as a tool of macroeconomic policy? Our answer was largely in the negative. RBI's actions of today are likely to shape up as yet another episode of this larger theme. It might make things worse for the rupee, for Nifty, etc.; to this extent these decisions would not be irrelevant.

Financial regulation should be focused on the problems of consumer protection, micro-prudential regulation, market integrity and systemic risk. It should not be used as a tool for short-term macroeconomic policy. If this is done, it damages market liquidity and yields a less capable financial market. This further damages the limited monetary policy transmission that RBI possesses.


  1. IMHO, RBI hasn't shifted to a floating rate at all, because: a) they never said so, thereby reserving the right to intervene and b) they just intervened right now.

    The test of having shifted to a floating rate is what RBI does when the rupee breaks the recent extremes at 40 or 50. They have intervened at both ends. Not doing anything when vol is low and when the currency is at comfortable levels (2009/2010) is hardly an indication of having shifted to a floating rate.

  2. Dear Ajay,

    Reading the blog first time I agreed with most of what was mentioned. But co-incidentally the weekly article of Gillian Tett, "Crisis fears fuel debate on capital control", in Financial Times discusses about likelihood of increase in activities of Central bankers in the future to use regulations as a tool for short-term macroeconomic policy. Now with increase in volatility of capital flows in the future the trend will increase. I am not sure if RBI can remain an island when all other Central Banks will resort to these type of activities.


  3. "Anonymous'" comments are interesitng. The strategic ambiguity about FX policy, then, is about as clear as its "multiple indicators approach" to monetary policy, no?

    So Ajay's conclusion still holds... this is lousy for RBI's credibility and can't be good for overall policy transmission.

  4. 1. "economic agents will be averse to holding India risk. This is bad for asset prices in India"

    This observation is enigmatic to me
    and seems to be more of a personal feeling of the Author, since, Economic Agents, who wish to do so, have been holding India Risk all the time; it is merely a highly variable risk perception on their part, which makes them invest or withdraw (in different degrees) from India. My qualitative feeling is that the RBI action would modestly influence their actions, if at all!

    2. Any of the Scholistic Readers of the Blog may help me if Federal Reserve of USA, Bank of England or the Bundes Bank of Germany have announced their shift to "Floating Exchange Rates" (I feel gratified, if the dates of such announcements are cited)

    3. I was a M.B.A. student in KUL in Belgium (1978-79) and could watch the attempts by SNAKE-members to keep the Snake in the Tunnel through actions similar to what RBI did just now; also, the concerted actions of US and Germany around 1986 stemmed the relentless appreciation of the Dollar (much attributed to large Capital flows into US during Regan era) and revived the rise of DM.

    3. The above instances are cited to support the ground reality that the Central Banks "Intervention Measures" did succced more often than not. I would surely admit the extent of Intervention was certainly on a vastly larger scale that what RBI did or could perhaps do (as Prof. Shah explained in RBI's case)

    4. Summing up, I wish to say that Capital Controls are indeed needed and could effectively be used and RBI should clamp the same at its wise discretion; let us also, appreciate, RBI is on its learning curve and is doing a laudable job all the time.

  5. Dear Ajay:
    The forward contract position which many of the industry hold in their books will lead to a trouble postion with higher interest rate regime. The skewed cash flow postion for industry may lead to a troubled position due to ecomomic crisis.There is no options left in our system for swapping of contract with firms like oil companies who would like to get in forward contract as low at 41 or 43 per dollar .
    The better bet it seems to be something like voluntary disclosure to bring back stuck balck money back to be pumped in the system.


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