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India, China and Exchange Rates

Omkar Goswami


Once again, I am going to do an India-China comparison. This time it is about foreign exchange reserves and exchange rate management. Hopefully, by the end of the article, you will be as convinced as I am that by letting the rupee appreciate the way it has, the Reserve Bank of India (RBI) is doing disservice to our economic prospects. And that Governor Zhou Xiaochuan of the People’s Bank of China is more perspicacious than his counterpart in Mumbai.


The graduate student’s textbook version of open economics unfolds thus. In any country, if the supply of dollars exceeds the demand for dollars, the price of a dollar falls. Hence, the price of the domestic currency vis--vis the dollar rises. If, however, the central bank continues to buy dollars, it creates demand for dollars and, thus, keeps the lid on the domestic currency’s appreciation, while increasing the country’s stock of foreign currency reserves. Here lies the rub.


For every dollar that the central bank buys, it has to release an equivalent amount of domestic currency. That increases money supply as well as bank credit. If the central bank is worried about inflation, it has to ‘sterilise’ the excess money supply. To do so, it must issue government bonds at an attractive enough coupon interest rate so that people willingly purchase such bonds for cash. The cost of such sterilisation for the economy is:


(The interest rate on domestic government bonds x number of bonds used for sterilisation) — (The US treasury bill rate x number of dollars thus invested, adjusted for the rupee-dollar exchange rate).  


With reserves rising from $193 billion in end-February 2007 to $213 billion by end-June, clearly the RBI is finding the task of sterilisation too onerous. Thus, from 20 March 2007, it has more or less let the exchange rate go — intervening only once in a while to buy dollars, and letting the rupee appreciate as it will.


In a space of 82 days between 19 March and 16 July of this year, the rupee has appreciated by 8.2 per cent against the US dollar, 4.3 per cent against the Euro, 12.4 per cent against the Yen, and 5.8 per cent against the Chinese renminbi.


Does it make sense? Textbook economist will tell you that the RBI has done just the right thing. It had to control inflation by tightening money supply and credit growth. And it couldn’t do so if it had to keep on buying the dollars that are coming in its billions and continuing to sterilise the rupee. It wasn’t just FII money; it was also NRI deposits and external commercial borrowing. Faced with an unprecedented inflow of dollars, it had to partially let go the exchange rate.


Now consider Governor Zhou and the People’s Bank of China. It has $1.2 trillion in reserves versus $213 billion in the vaults of the RBI. Net dollar inflows into China are far, far greater compared to India. Although inflation is not an issue, the People’s Bank also has the problem of sterilisation — indeed more so than India’s. So, you would expect the Chinese renminbi to appreciate at a far faster rate against the dollar than the rupee.


What are the facts? During the same period (19 March to 16 July 2007), the Chinese renminbi appreciated by a mere 2.38 per cent.


China’s dollar inflows are many times greater than ours. Everyone knows that ever since China agreed to experiment with its own version of the ‘float’, it has kept its currency strategically undervalued — with its central bank intervening time and time again to ensure a very slow, smooth, almost imperceptible upward crawl. Everyone knows that when the US Treasury and the IMF tell China to speed up the process of renminbi appreciation, these august bodies are politely told to shove off. So, China maintains its export competitiveness, builds world class infrastructure, attracts six times more FDI than India, and consistently grows at double-digits to become a $ 3 trillion economy.


Who knows the economics that matters? Governor Zhou or the RBI? You tell me.



Published: Business World, July 2007


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