India needs a currency stability fund: January 9, 2012 MInt

The fund will help improve confidence among investors by making more efficient use of the country’s reserves

Currency fluctuations always cause panic as sharp unidirectional movements shake the market. Anecdotal evidence shows a standard five-stage pattern in our reaction. First, the stance is that nothing amiss is happening. Second, we maintain that the rupee is market-driven and that there should be no interference. Third, we use the real exchange rate argument to show that while nominal rates are up/down, in real terms the rupee is actually undervalued/overvalued. Fourth, we say that we are helpless and cannot do anything since halting appreciation in currency has liquidity implications, while depreciation cannot be supported with our limited reserves. Fifth, we talk up or down the rupee with suitable measures to stem volatility, which could also mean direct or indirect intervention, which actually works.

Since unchecked significant movement in the currency is never desirable for any country, can we think of ways of intervention when the rupee falls so that the fundamentals can be corrected? To borrow an analogy from the farm sector, we have the concept of use of buffer stocks when commodity prices move up. Or closer to this market, forex inflows leading to currency appreciation is tackled by sterilization through the market stabilization scheme bonds that address the issue of monetization. There certainly must be a way of creating a buffer of dollars that can be selectively used for stabilization purposes when the rupee falls.
Intuitively, rupee depreciation hurts more for any country that has a current account deficit as there are more outflows than inflows indicating a net loss for the country. Add to these capital commitments such as debt service, and one can justify a halt to the free fall of the rupee through intervention. An issue raised is whether we have the wherewithal to provide such support. Does a number of, say, around $275 billion as foreign currency assets sound good enough for India, or is it inadequate? While there are certain contingencies that must be provided for by a central bank, keeping reserves beyond this level merits debate, especially as they are invested in Fed bonds, where returns last year were just about 1.8%. We can do better by using it to alleviate the pain of forex users in the country.

The table provides certain trends in components of forex requirements as a safety buffer.

The main buffers that have to be built by any central bank are included under “theoretical requirement”: four months of imports, which is the globally accepted prudential norm, or actual trade deficit, whichever is higher; short-term debt, which is hot money that may move out on short notice; debt service for the year (which is known in advance) and the highest outflow of foreign institutional investor (FII) funds in our history. In the case of debt service and FII outflows, $20 billion and $10 billion have been assumed, which is slightly on the higher side, as FIIs have only once had such outflows, and the debt repayment calendar released by the Union ministry of finance also includes short-term debt, which has been taken separately in its entirety. However, there is still nothing sacrosanct about this approach and the numbers can be tweaked based on the Reserve Bank of India’s (RBI’s) perspective.

The surplus that exists can actually be put into an exchange rate stabilization fund (ERSF), which will build up in times when there are more inflows and can be used to ensure that depreciation of the currency is more guided. RBI may choose a fraction of this surplus to be used for this purpose. The central bank, in turn, can hedge this fund on global exchanges to ensure that the risk is covered to a large extent. Quite interestingly, this ratio of surplus has been coming down over the years.
The idea of such a fund is not really bizarre, because we do see interventions in almost every market. The capital market has the insurance companies come in when things get volatile, and the government securities market is monitored through selective intervention by RBI directly or through proxy by public sector banks. Therefore, to do the same in the forex market makes sense. A declining currency is obviously not good for those who require dollars, and it also erodes global confidence in the economy, which can affect investment decisions. Foreign investors would buffer in this risk when putting in money as any withdrawal would become expensive. The same holds for companies borrowing from the euro markets.
How would this work? Ideally RBI should work within a band and intervene directly to stabilize the rupee. The central bank’s judgment can be used when looking at, say, the real effective rate that also adjusts the exchange rate with relative inflation.

By creating an ERSF, we can minimize the net loss for users of foreign currency, improve confidence of investors by making more efficient use of our reserves. It is an idea worth persevering with.