Exchange Rates, Growth and Crises

By A V Rajwade

Exchange rates, growth and crises is a collection that captures the author's ringside perspective of events as they unfolded in the large and tumultuous world of finance and economics over the past 25 years (post liberalization). The author has been a chronicler of his times for 30 years and in all his writings, India has always been at the center. Be it the financial crisis of 2008, the Asian crises or the numerous ways in which the global multilateral agencies have worked their might on the world, Mr Rajwade has diligently recorded the impact of these varied events on India. This book offers invaluable insight to students, professionals and all interested watchers of India's economic and financial story.

• Language: English
• Publisher: Bloomsbury Publishing
• Release date: Dec 15, 2017
• ISBN: 9789386643353

Book preview

Exchange Rates, Growth and Crises

BS Books

Exchange Rates,

Growth and Crises

A Collection Of Articles

A V RAJWADE

First published in India 2017

© 2017 by A V Rajwade

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Foreword

For readers of the financial newspapers, A V Rajwade has been a familiar by-line for many years, indeed a few decades. He has been read closely by policy-makers as well as by people in the financial markets and corporate world, and also by his former students from the Indian Institute of Management at Ahmedabad. As a sane voice on actively debated subjects, on which passing intellectual fashions have at times carried the day, Mr Rajwade has performed a valuable public service by consistently arguing a rational position, based on empirical evidence—even if (indeed, especially when) it is not one in line with what has been advocated by financial traders.

This collection of old newspaper columns reflects his primary concerns with exchange rates, currency markets and capital market accountability, and amply bears out his description of himself as a half-believer in market efficiency. That half-belief has helped his understanding of world financial markets and have led him to warn of impending problems before they turned into crises. In 2007 he wrote of the financial crisis brewing in US financial markets, even though he did not anticipate the extent of the collateral global damage that would result. Very early on in the Greek crisis, in 2010, he asked the basic question that those in charge initially side-stepped because it was inconvenient: was the crisis was one of liquidity or solvency? And in the months ahead of the taper tantrum of 2013, when the rupee plunged sharply, Mr Rajwade was writing that the situation with regard to India’s external account (including large current account deficits) was unsustainable.

The issues that Mr Rajwade writes about are important, indeed vital, because much economic damage and human suffering has been caused by wrong financial policies, like defending an unsustainable exchange rate—or for that matter by maintaining high exchange rates for long periods, as India has done. He correctly identifies a key lesson from the 2008 crisis, that the financial economy should sub-serve the real economy, not the other way round. And he dismisses the International Monetary Fund’s earlier belief in capital account convertibility as driven more by ideology than by empirical evidence. Indeed, he wonders whether its modified position today is a real change or only a cosmetic one. Elsewhere, he points out that the Reserve Bank’s hands-off policy on the rupee’s exchange rate (leaving it to the market) after a new governor took charge in 2008, was a serious error as it led to increasing current account deficits.

Not everyone will agree with these positions, but that is precisely the point—Mr Rajwade is willing to argue his position, even if it is not a popular one in the financial world. Some of his other hobby-horses, like the contention that remittances should be treated as capital transfers, not current account transactions, have found virtually no takers in the policy-making world, but they do make you think. His larger point, that India faces the Dutch disease of excessive dollar inflows that take up the rupee to a level where it discourages exports (hence his plea for RBI intervention), is one that needs to be recognized as needing wider recognition.

The problem with collecting short pieces written over many years and putting them between two covers is that some repetition of common themes becomes unavoidable. Nevertheless, Mr Rajwade has done a service by putting together this compendium, with an exposition of core arguments that have stood the test of time.

T N Ninan, Chairman Business Standard

Preface

Looking back on four decades of financial journalism

When I left SBI in 1976 after coming back from a posting in London, I had not imagined that I would be contributing articles to premier business publications in India for the next 40 years: first, The Economic Times, then Business Standard, Mint and back to Business Standard—with occasional articles in the Economic and Political Weekly and other periodicals. The starting point was accidental, and the timing fortuitous. The currency market was just becoming more active in the ‘floating rate era’ and during my stay in London, I had developed an interest in it, particularly thanks to the Financial Times (FT). Back in India, while I had taken a job in a company after leaving SBI, I was missing the FT.

As it so happened, the partner of a firm of brokers, well known in the Mumbai foreign exchange market, came to me to talk about producing a weekly bulletin on currency markets. The bulletin was meant for the firm’s clients. I was only too happy to accept the offer as it meant daily access to the FT. The format of the bulletin was simple: a commentary on exchange rate changes during the week accompanied by a table that tracked the change and an article on a topical issue.

At that time, there was very little coverage of the currency market in Indian media. The Economic Times was the only business daily doing that. Dr Hannan Ezekiel, ex-IMF economist and one of the authors of the special drawing rights (SDRs) scheme, was the then editor. A couple of issues of the bulletin came to his notice and he sent across a request for a meeting. When we met, he suggested that I write a monthly report on the currency market for the newspaper. The title, ‘World Money’, was coined by him. After a few months, he felt that it needed to be converted into a weekly report and so it all began.

The weekly market report soon became a weekly column that took the shape of an opinion piece on topics such as:

Global economy, banking and financial markets

Multilateral institutions like the International Monetary Fund and World Bank

India’s balance of payments

Monetary policy

Political economy

Derivatives and risk management, etc.

While my foray into financial journalism was accidental, the entire journey, I must say has given me considerable professional satisfaction and recognition.

In the mid-1980s, I was pleasantly surprised to receive an invitation from the Indian Institute of Management, Ahmedabad, to teach a course on international banking and finance as a visiting professor, which I did for about five years. Given the quality of the IIM-A students I taught, I had to constantly keep myself updated and abreast with the latest developments which entailed considerable study of the historical and academic dimensions of the subject at hand, which I otherwise would not have done. In fact, I have often wondered whether, in the process of teaching at IIMA, I learnt more than the students!

Later, I was invited as a member of several committees appointed by the RBI, including those on capital account convertibility. I imagine that these appointments were based on what I was writing rather than on any other qualifications as I was neither a senior banker nor an economist.

My writing furthered my risk management consulting work. Clients approached me after having read my views in print. Later I served as an independent director on two Mauritius-based, British-managed fund management companies investing in India. They had a vital interest in the rupee’s exchange rate, a topic I had explored in depth in many columns. Many companies that had suffered losses on account of their involvement with structured derivatives that they had entered into with their banks came to me too, having read my articles on derivatives.

Perhaps most gratifying were the mostly positive responses that I received from market participants, senior commercial and central bankers, academics and other from across the world.

Last year, I was conferred the Shriram Sanlam Hall of Fame Award for financial journalism.

In retrospect, the 40-year journey has been interesting and gratifying.

Last year, Mr T N Ninan suggested that I should come out with a collection of my articles in a book. In consultation with the team at Business Standard Books, I chose to focus on exchange rates, growth and crises as the underlying theme for the collection. And in keeping with that the articles are separated in three sections as follows:

Section I: Capital account liberalisation, exchange rates and IMF

Section II: Other emerging economies’ experiences

Section II. i: Growth

Section II. ii: Crises

Section III: India’s exchange rate policy and growth

I am grateful to Mr Ninan for writing the foreword. I am also grateful to my former colleagues in SBI, Mr Balkrishna Patwardhan and Mr Vasant Warty, for helping in the selection of articles. My thanks are also due to BS Books for help in selection of articles. The collection could never have been prepared without the meticulous work of my secretary, Ms Shital Lodhavia, who has suffered me for more than two decades now!

The end result is now in your hands.

AV RAJWADE

About the book

Exchange rates, growth and crises is a collection of columns that captures the author’s ringside perspective of events as they unfolded in the large and tumultuous world of finance and economics over the past 25 years (post liberalisation) and maybe a bit more. The author has been a chronicler of his times for 30 years and in all his writings, India has always been at the centre. Be it the financial crisis of 2008, the Asian crises or the numerous ways in which the global multilateral agencies have worked their writ on the world, Mr Rajwade has diligently recorded the impact of these varied events on India. This book offers invaluable insight to students, professionals and all interested watchers of India’s economic and financial story.

Contents

Foreword

Preface

About the book

Section I

1. Exchange Rates: The Tobin Tax

2. Carry Trade and Exchange Rates

3. Financial Market Efficiency

4. Yen’s Exchange Rate and The Carry Trade

5. The Sub-Prime Mess and Exchange Rates

6. Financial Regulation: Managing Exchange Rates

7. Exchange Rates, Capital Flows, etc.

8. IMF Research on Capital Flows

9. Vicious Circles

10. Gold Standard and The Impossible Trinity

11. Real and Financial Economies and Exchange Rates

12. The Emperor’s New Clothes

13. A New IMF MD and The Capital Account

14. The IMF’s Ideological Bias

15. G-20: Financial Regulation and The Real Economy

16. Seventy Years of The IMF

17. Capital Flows and Exchange Rates

18. Efficient Markets and Exchange Rates

19. ‘The Global Monetary Non-System

20. Leopards Changing Spots?

Section II: Other Emerging Economies’ Experiences

Part I: Growth

21. India and China

22. Is China The Next Domino?

23. Beginning of the Transfer of Power?

24. The East is East…

25. The Globe’s Second Super-power

26. China and India: The Odd Couple

27. China’s Global Economic Power: Yuan as a Future Reserve Currency

28. China’s Impact on Global Markets

Part II: Crises

29. Making The Rich Richer

30. Currency Crises

31. East Asia Revisited

32. Double Standards?

33. Argentina: Too Big to Fail?

34. Argentina, IMF and Debt Restructuring

35. Rescuing Finance Capitalism

36. Capital Account Convertibility

37. The G-20 Finance Ministers Communiqué

38. The G-20 Summit

39. The Impossible Trinity and CAC

40. CAC and Financial Crises

Section III: India’s exchange rate policy and growth

41. Monetary Policy Follies

42. Currency Market Fashions

43. Financial Markets Potpourri

44. Faltering Growth and Monetary Policy

45. Liberal Capital Account and Emerging Markets

46. Commodity Hedging Lessons

47. Convertible Currency Movements

48. Exchange Rate Policies

49. The Level of Reserves and Capital Account Convertibility

50. The Real Exchange Rate and Deficits

51. The Impossible Trinity and The Exchange Rate Policy

52. Exchange Rate Policy

53. Intriguing (and dangerous?) Complacency

54. Market Determined Exchange Rates

55. The Fall of The Rupee: Background, Remedy, and Policy

56. BoP: Problem of Liquidity or Structural?

57. CEAs and Exchange Rate

58. Current Account and The Exchange Rate

59. India: External Sector, Growth and the Exchange Rate

60. The Original Sin

61. India’s ‘Dutch Disease’ and Exchange Rate

62. ‘Make in India’ and The Exchange Rate

63. Maintaining Growth in India

64. IMF’s Report on India

65. External Account and Sovereignty

66. A ‘Bullet Proof’ Balance Sheet?

67. The External Account: UK and India

68. Balance of Payments Data: Numerator and Denominator

69. Advancing Asia Conference

70. Exporting the Exchange Rate?

71. Exchange Rate Policy and India’s External Account: The Last 25 Years

References

About The Author

Section I

The first section focuses on the institutional view of the International Monetary Fund on the subject of cross-border capital flows and on exchange rates. Over the years I have come to believe that the IMF views on capital account and market determined exchanged rates are more the result of a neoliberal economic ideology than based on empirical evidence; biased in favour of the financial economy than the real economy; and that the emerging economies need managed exchange rates. The recent changes in the institutional view seem more cosmetic than substantive.

The selected articles argue the issues involved.

1. Exchange Rates: The Tobin Tax

The death of Nobel laureate James Tobin last month has re-triggered the debate on his three-decades-old proposal to levy a tax on currency conversions. The proposal was to levy a small ad valorem tax, aimed at discouraging—by making them costlier—short-term, speculative foreign exchange transactions, without inhibiting the movement of long-term investment capital. Tobin acknowledged in an interview in Der Spiegel, published on September 2, 2001, the origin of the idea: ‘I am a follower of Keynes who, in his general theory on the stock crash of 1929, had suggested a turnover tax to marry investors more durably to their assets.’ Tobin mooted the proposal in a 1972 lecture and while confessing that ‘the idea fell like a stone in a deep well’, tried to resuscitate it in 1978 in his presidential address to the Eastern Economic Association, Washington.

Before discussing some aspects of the Tobin Tax, it is as well to refer to some of the points Tobin made in the 1978 lecture. He argued: ‘Goods and labour move, in response to international price signals, much more sluggishly than fluid funds, than the prices of financial assets, including exchange rates.’ Given the gyrations in exchange rates amongst major currencies, Tobin remained, ‘sceptical that the price signals these unanchored markets give are signals that will guide economies to their true comparative advantage, capital to its efficient international allocation and governments to correct macroeconomic policies.’

In other words, freely floating and volatile exchange rates are an impediment to globalisation—of production of goods and services based on comparative advantage—and al-location of capital in a way to maximise output.

According to Tobin, ‘There are two ways to go. One is toward a common currency, common monetary and fiscal policy, and economic integration. The other is toward greater financial segmentation between nations or currency areas.’ He did not consider the first one to be ‘a viable option in the foreseeable future, i.e. the 20th century. Even for the common market countries, the goal is still far, far distant’. While his point remains valid, as far as Europe was concerned, he was to be proved wrong within two decades of the 1978 address with the birth of the euro.

This apart, his proposal for a tax on currency conversions was born of the conviction that of the two ways, the first, a single currency, is not feasible, and the second, a fragmented world, not desirable. Hence the via media of a tax to discourage short-term currency speculation and, hopefully, significant and persistent exchange rate movements away from an equilibrium rate. The tax was aimed at throwing ‘some sand in the wheels of our excessively efficient international money markets’. But, to quote Tobin on market efficiency, ‘I mean the word efficient only in a mechanical sense: transactions costs are low, communications are speedy, prices are instantaneously kept in line all over the world, credit enables participants to take large long or short positions at will or whim. Whether the market is efficient in the deeper economic-informational sense is very dubious. In these markets, as in other markets for financial instruments, speculation on future prices is the dominating preoccupation of the participants. In the ideal world of rational expectations, the anthropomorphic personified market would base its expectations on informed estimates of equilibrium exchange rates. Speculation would be the engine that moves actual rates to the equilibrium set.’ In fact, ‘in the absence of any consensus on fundamentals, the markets are dominated—like those for gold, rare paintings, and yes, often equities—by traders in the game of guessing what other traders are going to think’—Keynes made the same point much more colourfully in his famous parallel to choosing pretty girls! But that apart, question remains—whether one agrees with Tobin or not, with what admirable lucidity he expresses himself!

If the idea of a Tobin Tax never took off, there were several underlying reasons:

Powerful lobbies have a vested interest in volatile exchange markets. The aggregate ‘trading’ i.e. speculative profit earned by commercial and investment banks, and hedge funds, much of it in currency markets, probably runs to anywhere from $50 billion to $100 billion a year.

The feasibility of levying the tax is questionable. Forex trading may simply migrate to tax havens Martin Wolf recently argued in the Financial Times that ‘feasibility… does not seem as big an issue’, the tax is collected at the point of settlements which, inevitably, takes place in the major money centre—not in Bermuda! His optimism may not be realistic—various netting systems will ensure that the amounts actually settled are a very small percentage of the aggregate transaction volume.

It is uncertain whether the tax will stabilise exchange rates.

Tobin’s idealism suggested that the proceeds of the tax be used by the World Bank to assist poverty eradication, a proposal against the grain of today’s aid-weary world.

But the idea of limiting excessive currency movements through taxation is not quite dead. The French parliament passed legislation on the subject some time back; the Belgians have now followed suit. Maybe, a Tobin tax, some variation of it, could well be the reality 10 or 20 years from today. It matters little to him now. To quote Paul Krugman’s tribute to him ‘He was a great economist, a remarkably good man; his passing seems to me to symbolise the passing of an era, one in which economic debate was both air and a lot more honest than it is day... when economists of such fundamental decency could flourish, and even influence policy’.

WORLD MONEY, Business Standard, April 1, 2004,

2. Carry Trade and

Exchange Rates

The so-called ‘carry trades’ have been a favourite ploy of international investors and hedge funds. Incidentally, calling such traders as ‘investors’ unnecessarily glorifies the activity of what is, all said and done, speculation. Journalistic distinction is that if you are successful in speculation, you are praised as an investor as, say, George Soros is—if you fail, of which there is an equal chance, then you are branded a greedy speculator.

‘Carry trades’ involve borrowing in low interest currencies and exchanging them for, and investing in, currencies which have high interest rates or yields. There is an obvious exchange risk and it cannot be hedged if the trade is to result in a profit. (Given the interest parity principle in the foreign exchange market, the forward margin would nullify the interest differential.) The ‘investor’ therefore takes the exchange risk, but hopes to gain, if the borrowed currency is either stable or weakens, in relation to the invested currency. In the latter case, you make money not only through the interest differential but also on the exchange rate. You would lose only if the borrowed currency appreciates more than the interest rate advantage of the trade.

‘Carry trades’ have been in the news recently as the international interest and exchange rate scenario has changed. The recent fall of the high interest rate currencies of Iceland, Hungary, and Turkey is attributed to the reversal of carry trades. ‘Carry trades’ were also popular with the comparatively high yielding New Zealand dollar as the investment vehicle. But, both the Australian and New Zealand dollars depreciated in the first quarter of the current year in $ terms. The trend has reversed in April with the general weakness of the US currency against almost all others. Indeed, the recent weakening of $ has provoked at least some analysts to contemplate that horror—namely that markets may have started focusing on structural and fundamental problems like the US trade gap.

In any case, at least some central banks seem to be getting worried about the medium term prospects and are reducing exposure to the US dollar. Such central banks include those of Sweden, Russia, Qatar, UAE and Kuwait. The ‘big gorillas’ are of course the east Asian central banks. The Chinese and Japanese central banks by themselves probably hold half the world’s reserves of foreign exchange. The big question in terms of the fate of the US dollar is whether (when?) China and Japan would follow some of the European and middle-eastern central banks. The IMF has now been given the task of multilateral surveillance of exchange rates—in other words, to facilitate co-operative action on the part of different countries and their macro-economic policies, in order to reduce global imbalances (i.e. the US deficit). It seems a very tall order for the IMF to persuade the US to cut its budget deficit or the US consumer to save more, which will be necessary. In its absence, trade protectionist lobbies in the US will gain strength, with all that this may entail for global growth.

But to come back to ‘carry trades’, the most spectacular impact of their reversal was seen in the yen: dollar market in 1998. For a few years, a very popular and lucrative trade was to borrow yen, buy dollars and invest in US treasuries. Not only was the interest differential very attractive, but the yen moved from JPY 79 to a dollar in April 1995, to JPY 147 in summer 1998. What triggered a change in the scenario was the collapse of LTCM, the highly leveraged hedge fund, leading to banks cutting down their credit lines to all hedge funds. They were thereby forced to reverse the trades by buying yen and the yen moved from JPY 136 to JPY 112 in a couple of days, the most spectacular exchange rate change I have witnessed.

‘Carry trades’ are hardly unknown in India—except that they are trade-linked and not merely financial transactions. For example, foreign currency credit on imports, and to that extent borrowing less rupees (or adding to invested rupee surpluses), leaving the exchange risk uncovered, is also as much a ‘carry trade’ as what hedge funds undertake in financial markets. Such trades were very popular and profitable with Indian corporates when dollar interest rates were much lower and the rupee was appreciating. Both factors have changed recently, and one is seeing that the corporate sector is now less enthusiastic about taking large dollar exposures. If the trend gathers momentum, it has serious implications for both interest and exchange rates.

WORLD MONEY, Business Standard, May 8, 2006

3. Financial Market Efficiency

Believers in the totality of the efficient market theory would have surely had their faith shaken by recent happenings in the currency, commodity and equity markets. On the other hand, those who do not believe that man always acts rationally, that emotions, fashions, trends and the herd instinct play a major role in financial markets, as the proponents of behavioural finance argue, would have found much to confirm their views.

But first the question of market efficiency arises. The efficient market theory argues that markets react to news (and news alone); and that, therefore, market determined prices of assets (equities, currencies, commodities, etc.) reflect their fundamental values, based on all known information. Market efficiency also requires liquidity, low transaction costs, the availability of