Exchange Rate Regimes and Incentives

1. 1 Exchange Rate Regimes and Incentives Ashima Goyal IGIDR, Mumbai and CGU, Claremont Claremont-IIE Workshop, IIE November 3, 2004

2. 2Exchange Rates

3. 3Exchange Rates • Market determined but limit volatility if it occurs-in practice fix and depreciation during volatility • Competitive equilibrium real exchange rate—internal and external balance over time • Reserves cross 120 billion dollars—stability of inflows? Incentives to minimize risk, NIFA, regional initiatives

4. 4Exchange Rates • Growth slowdown 1997-2002 • Nominal interest rates raised to reduce exchange rate volatility • Correlated with I fluctuations • Temporary supply shocks • Volatility of current account higher than capital account policy aggravated shocks from capital inflows

5. 5Exchange Rates • Growth revival after successful drop in nominal interest rates, and more two way movement of exchange rate • Reversal of steady trend depreciation of the nineties • Indian inflation higher than world 4-5 : 1-3  real appreciation; depreciation required • Higher productivity growth  appreciation can occur; exports not affected • But the Chinese factor?

6. 6Exchange Rates • Political traps for exchange rate policy • Fix--nominal anchor for inflation; consumers • More flexible--surprise inflation; CB inflation bias to increase output despite wage rigidities; exporters

7. 7Exchange Rates • Managed floating has worked (so far) in India. Why? • Initial resistance to devaluation but importance of export growth accepted • Inflows, reserves, sterilization but bouts of volatility used for trend depreciation to compensate for inflation differential

8. 8Exchange Rates • Avoiding political traps and crises • No overvaluation: inflation relatively low, e not used as a nominal anchor—no nominal fix • No undervaluation: e not used to create inflation; politics imply aversion to high inflation; structure implies surprise inflation does not remove output distortions; no inflation bias even though CB not independent • But transfer bias, subsidies and fiscal deficit--administrative distortions to restrain inflation • Two major successful political groups: farmers demanded and got rising support prices, poor required constant food wages and got subsidies

9. 9Exchange Rates • Using structure • Below potential or full capacity output; dualistic L market • Short-term bottlenecks which inflows can help relieve; high longer-term supply elasticity • One reason for fall in inflation– with more openness border prices moderating politics of food price support • Food large share in consumption basket  e affect CPI inflation • Large share of oil imports  e affects producer prices

10. 10Exchange Rates • Using structure to do better • Two way movement of e; limited volatility –- 5% p.a.? • Deepen markets; incentives for hedging • Monetary stimulus preceding a temporary supply shock can lower i rates, raise output, appreciate e, reduce inflation, supported by forex trader actions. • Monetary policy can be more countercyclical • Intervention required only if e overshoots the bounds set

11. 11Exchange Rates • If linked to supply shocks would overcome CB’s status quo bias • Appreciation could offset temporary supply shock • Supplemented by inflation zone targeting and stronger fiscal rules to restrain “transfer bias”

12. 12Exchange Rates AD LAS

13. 13Exchange Rates • Inflation > 5%; oil price > OPEC target band $ 22 - $28, since Jan.; peak $ 35.6 mid-March; stronger rupee helped decrease inflation 4.3% • But depreciation after that; delayed monsoon oil prices breached $50; inflation rose to peak 8 percent • Government decreased tariffs on oil, took a revenue loss; inflation fell; more administrative distortions? Thank you