Contemporary Concerns Study

Study of Monetary Policy vis-à-vis Exchange Rates and Related Impact on Exchange Rate Risks and Forex Markets

Partial Fulfillment of the Requirements for the

CCS Course in the

Post Graduate Programme for Management

Prof. Shyamal Roy

August 29, 2006

Mohit Gupta (0511102)

Shubhankar Nayak (0511119)

Indian Institute Of Management, Bangalore

Acknowledgements

We would like to extend our sincerest gratitude to Professor Shyamal Roy for giving us the opportunity to work on this project. he has been our constant source of guidance throughout the course of the project. We hope that this contemporary concerns study is a proper reflection of our efforts and imbibed insights on exchange rate management in india and related concerns.

Objectives of Study

Monetary policy of an economy outlines the broad direction of the economy in terms of domestic growth, prices, movement of interest rates and exchange rates. These variables have ripple effects on various stakeholders in the economy. With global integration of Indian economy, Exchange Rate movements are playing an important role through their direct/indirect effects on the economy. The objective of our study is twofold: (1) To analyze the various policy measures/options that Reserve Bank can take in influencing exchange rate movements. (2) To focus on RBI’s current stance on exchange rates and Forex reserves, and the effectiveness of its policy measures.

Table Of Contents

Serial No. Title Page No.

1. / Executive Summary / 5
2. / Literature Survey, Data Sources, and Methodology / 7
3. / Introduction to Monetary Policy / 9
4. / Analysis Of Balance Of Payments / 11
5. / Exchange Rate Management By RBI / 17
6. / Effectiveness OF RBI Intervention / 27
7. / Analysis Of Forex Reserve Management / 29
8. / Managerial Implications / 36
9. / Conclusion & Limitations of Study / 37
10. / Appendices / 39
11. / References / 48

Executive Summary

“Monetary policy making has become a delicate balancing act between the imperatives of domestic economic, financial and monetary concerns and the evolving international situation that we have to observe closely on a real time basis and to take it as a given” –Rakesh Mohan, Deputy Governor, RBI

Monetary Policy of an economy is the policy statement through which the Central bank of an economy seeks to ensure price stability amidst factors like money supply, interest rates, and inflation. In the Indian context, the post-liberalization era of 1991 onwards has seen a paradigm shift the operations of Reserve Bank of India (RBI)[1] in the face of surges in capital flows, integration of India with world trade and finance, and hence the external sector of India. The aim of our study was: 1) To analyze the policy targets of RBI amidst the conflicting goals of price, interest rates, and exchange rates stabilization 2) To analyze the nature and efficacy of RBI’s intervention in the Forex markets and hence the movement of exchange rates 3) To perform a cost-benefit analysis of optimality of India’s burgeoning Forex reserves.

In order to meet the challenges thrown by financial liberalization and the growing complexities of monetary management, the Reserve Bank switched from a monetary targeting framework to a multiple indicator approach from 1998-99[2]. Short-term interest rates have emerged as the key indicators of the monetary policy stance.India’s current exchange rate policy has been focused on managing volatility without a fixed rate target. We feel that RBI is targeting a stable real effective exchange rate (REER), and is using interest rates as a policy tool to adjust these forces in the economy.

The Balance of Payment analysis showed that there is also an increasing influence of capital flows in determining exchange rate movements as against trade deficits and economic growth in the earlier years. While this positively reflects the integration of India with global markets, the quality of the capital flows can be questioned considering the volatile Portfolio investments. RBI intervenes in the Forex markets through direct purchase/sale of dollars through sterilized intervention in its aim of avoiding volatility in rupee movements in either direction. Our study showed the pros/cons of this strategy and over the last 3-4 years, RBI hasn’t even gone for a complete sterilization. Moreover, the intervention of RBI in the Forex markets can be questioned as a circular effect which has not stabilized and it had to continuously intervene in the Forex markets. This poses questions on the stability of the underlying economy and its transmission mechanisms vis-à-vis increased capital flows.

One of the direct effects of the exchange rate management has been the build up of India’s foreign exchange reserves which is now the sixth largest in the world. While there is no doubt about the economic importance of Forex reserves, especially for a developing economy like India, we have analyzed the optimality of India’s foreign exchange reserves. Our Analysis shows RBI is maintaining excess forex reserves irrespective of method taken for calculating optimal forex reserves level.There is a trade off in maintaining huge reserves. On the flip side there is maintenance cost incurred by RBI which is due to interest rate differentials between US and IND. But maintaining reserves help it in insulating external sector and Indian export competitiveness by intervening in forex markets as and when required. Also since most of the reserves are of portfolionature, which are volatile therefore it also justifies current level of reserves.We also looked into alternate possibilities of utilizing India’s foreign reserves in infrastructure financing and domestic growth.

The ultimate success of monetary policy could be judged in terms of inflation conditions and RBI’s ability to maintain stable conditions in the financial markets. The inflation record over the past five years is satisfactory as compared to other developing economies.The Reserve Bank has so far been able to balance its objectives of exchange rate and monetary policy objectives by choosing an intermediate exchange rate regime coupled with partial sterilized intervention.

Literature Survey, Data Sources, and Methodology

External sector discussed by Dr. Shyamal Roy[3] in his book “Macroeconomic Policy Environment” provided the basic framework of the CCS. The chapter starts off by discussing the importance of external sector for an economy. Various variants of exchange rate i.e. fixed, flexible and managed float are discussed. Balance of Payment (BOP) is then analyzed and is linked to exchange rate determination. The important point discussed is that unlike in the fixed exchange rate system where macro economic adjustments take place through money supply changes, in a purely flexible exchange rate system adjustment takes place through changes in exchange rates. In managed float RBI allows exchange rate to be market determined and intervenes if it gets disorderly. The chapter highlights the importance of financial sector reforms and finally ends with discussion about recent forex reserves.

In the chapter Exchange rate determination and forecasting, Prof. P G Apte[4] discusses two important theories namely Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) in detail. The chapter mentions that PPP holds only in long run and when real exchange rate is stationary over the time horizon. Thus, utility of PPP is negligible for managers in taking quick decisions. Interest Rate Parity predicts exchange rate on the basis of interest rates differentials and holds true to prevent arbitrage opportunities.

Dr. Y V Reddy[5] in his speech “India’s Foreign exchange reserves – Policy, Status and issues BIS Review 30/2002”, mentions three motives of storing forex reserves. These are Transaction motive (to handle international trade), speculative motive (to gain by favorable exchange rate movements) and precautionary motive (to store reserves as cushion against sudden demand supply mismatches). He mentions that primarily it’s the precautionary motive which is dominant in most of the cases for storing excess reserves.

Mr. Vijay Joshi in his paper “The Real Exchange rate, Fiscal deficits and capital flows: A Refutation[6],” estimates the real impact of storing huge excess reserves in terms of lost GDP growth rate as an opportunity costs. This paper calculates the GDP which would have resulted by investing full amount of forex reserves over the years 1991-2000. We have used this framework to come up with similar cost paid in terms of lost GDP growth rate for the last five years.

Sumon Kumar Bhaumik and Hiranya Mukhopadhyay in their paper " RBI’s Intervention in Foreign Exchange Market:An Econometric Analysis" address the issue of circular nature of RBI's intervention in forex markets. They say that intervention affects the exchange rate in two ways, first, by affecting the extent of excess demand in the foreign exchange market, and thereafter through a complex interplay of the macroeconomic variables. The subsequent empirical results indicate that the effect of RBI’s intervention in the foreign exchange market is at best unclear.Specifically, given the time span of the data, the RBI’s interventions in the market seem to have been ineffective.

Data Sources

RBI site provided the base for most of the data required for carrying out mathematical modeling. The data was collected from RBI bulletins. In addition to this Money & Finance journal published by ICRA was also referred for taking key information. Central Statistical Organization’s website was used for taking price levels (WPI and CPI). US fed reserve website was used for getting important information like yield of US t bills and spot rates. Indianstat.com was used to gather important macroeconomic related data for over several years. Finance ministry website was also used for getting relevant information for the CCS.

Methodology

The CCS project first began with reading of basic articles and chapters to get an in-depth understanding of monetary policy operations and related levers. This was followed by a phase of creating mathematical models for exchange rate determination and frameworks for arriving at key conclusions like costs of maintaining excess reserves etc. Our guide Dr. Shyamal Roy provided great help in finalizing the models and frameworks. In addition to this several articles from leading publications like Economic & Political Weekly also provided required inputs for these frameworks. Data was collected from related online resources and journals and models were tasted to verify the hypothesis. Finally based on this analysis key interpretations were drawn.

Introduction to Monetary Policy

Monetary policy works through change in money supply. This leads to impact on financial variables, aggregate demand and finally GDP and prices. Monetary policy can target money supply, interest rates or exchange rates to achieve goals. However it is not possible to achieve all three at one go. The broad objective of monetary policy in India seems to be price stability and sustained growth in output.

Monetary Policy Transmission Mechanism[7]

The efficacy of monetary policy depends on both stability of money demand and supply function. On demand side key variable is income velocity of money while on supply side its RBI’s ability to control monetary base and coefficient of money multiplier. All of these variables are unstable. This coupled with the fact that monetary policy effects are seen after a lag necessitates pre-emptive action from RBI.

Monetary policy is closely linked with the fiscal policy because excessive borrowing from the market may force RBI to increase the money supply to arrest the increase in interest rates. But it may lead to inflation. Therefore there is constant trade off between whether to let prices or interest rates let loose. In India, primary motive of monetary policy is price stabilization. With increasing integration of Indian economy with other countries exchange rate stability is also assuming considerable importance. Through this CCS we intend to study the later part of monetary policy objective i.e. exchange rate stabilization and related issues like benefits and cost analysis.

Analysis of Balance of Payments

Balance of Payment statements (BOP) is basically a statement of the difference between the supply and demand of foreign exchange. If the supply of foreign exchange is greater than the demand for foreign exchange, Rupee will be under upward pressure and vice-versa. Hence, analysis of BOP statements and their trends[8] is critical to understanding the determination of exchange rates.[9]

The last two years have seen significant changes in India’s BOP position which could signal greater external sector vulnerability.

Current Account Balance[10]

India’s current account balance witnessed a deficit in 2004-05 and 2005-06 after three years of rising current account surplus. This was driven by a large merchandise trade deficit reaching 5.5% of GDP in 04-05 and expected to touch nearly 6.5% of GDP in 05-06. The invisible balance growth (33% in 05-06) has been driven by services (esp. Software) export growth and private transfers.

The sustainability of current account deficit (CAD) is situation-specific.

Positive Factors:Firstly, Non-oil imports have been driven primarily by imports of capital goods and mainly export-related items. The rising import trends are, therefore, reflective of enhanced domestic activity and demand from exports.Secondly, the financing of the current account has not posed any challenge as it has been financed through normal capital flows without recourse to foreign exchange reserves.
Negative Factors: Uncertain international crude prices and expected moderation in domestic as well as global growth in 2006-07 raise concerns about sustainability of the CAD.

Trade Account Balance[11]

Both merchandise imports and exports have seen huge growth spurts in 2004-05 and 2005-06. This is attributable to India’s resurgent competitiveness in the manufacturing sector, rising international commodity prices, conducive macroeconomic policies, and a global demand recovery. While a widening trade deficit is a cause of concern (primarily attributable to rising crude oil prices), the quality of imports/exports have improved over the years

Trend Analysis of Imports and Exports

Year / 2001 / 2002 / 2003 / 2004 / 2005 / 2006
GDP / 445181 / 483032 / 516212 / 605000 / 689108 / 735852
Imports / 57912 / 56277 / 64464 / 80177 / 118961 / 156334
% of GDP / 13.01% / 11.65% / 12.49% / 13.25% / 17.26% / 21.25%
Exports / 45452 / 44703 / 53774 / 64723 / 80831 / 104780
% of GDP / 10.21% / 9.25% / 10.42% / 10.70% / 11.73% / 14.24%

*Merchandise exports/imports

India has become relatively more outward-oriented in the last five years which is reflected in the growing contribution of Exports to India’s GDP. Long-term sustainability of inflow of dollars is dependent on the contributions from the manufacturing sector. Private Transfers, which are a big component of Invisibles flow, can be volatile. Due to the rising imports, the current account balance has not played a significant role in the recent burgeoning of Forex reserves. We feel that despite the rising import bills, the fact that Capital goods and Export-related item imports still constitute nearly 40% of imports augurs well for India’s productive capacity.

Capital Account Balance[12]

The Capital Account Balance has shown an increasing trend since 2003. However, considering the diversity in the composition of Capital Account in terms of stable/volatile capital flows, it is important to analyze the trends in various components of Capital account balance.

Foreign Investment

FI is of two kinds: Portfolio and FDI. Foreign Institutional Investments (FII) led the growth in net capital inflows, accounting for nearly 72% of FI flows over the last 3 years. The periods April-May 2005 and recently April-June 2006 saw significant off take of volatile capital from Indian equity markets by the FII’s due to rising oil prices and the resulting global uncertainty and the upturn in the interest rate cycle
Capital inflows through the issuances of American depository receipts (ADRs)/global depository receipts (GDRs) increased substantially in lieu of booming stock markets.
In comparison to FII flows, the more permanent FDI flows were stagnant in the period 2003-05, but have made a strong comeback in 05-06 (FDI inflows witnessed a 43% yoy growth while outflows remained at last year’s levels).
The rise in sectoral hikes in telecom (49% to 74%), and in air transport services (40% to 49%) resulted in significant interest in these sectors.
Outward FDI flow, on account of increasing M&A activities, has also increased smartly over the last 2 years.
Indian Capital markets are one of the most sophisticated in the world today and the interest shown by FII’s to put significant moneys into India has aided in its development. But FII’s are basically looking at arbitrage opportunities in various markets, purely on basis of trading margins. This money is very volatile, and can/has caused distress in Indian markets on with drawl of funds.

Banking Capital

NRI deposits witnessed a comeback in 05-06 after significant outflows in 04-05 reflecting the re-alignment of returns on NRI deposits and global interest rates.

Loans

The short term capital flows have risen over the last 5 years due to the borrowing requirements of India to finance its excess import bill, due to rising oil prices. In 2005 short term borrowings as a percentage of reserves stood at 4.3%. The short term borrowings should be kept at low levels.

Strong domestic investment demand and favorable financing conditions abroad led to a stupendous ECB outflow of $6 billion in 2005 following the deficits of the previous years (due to repayment of borrowings out of Forex reserves). As expected, this jump slowed down in 2006 albeit still a sizeable $1.6 billion of ECB.