Strengthening of the inr: total convertibility of the capital account and gods on banknotes

The Deputy Governor of the RBI recently advocated floating the Indian Rupee (INR) so that it finds its level based on demand and supply. His suggestion comes as the RBI pumping up to $114 billion to back the INR has failed to stem the rot.

RBI has multiple mandates. Two of them are inflation control and foreign exchange reserve management, a subset of which involves restoring the value of the INR through skillful tightrope walking consisting of sterilization operations.

When the INR slips too much against the dollar, which makes imports expensive, RBI pumps in dollars, i.e. sells dollars, thereby increasing its supply and stemming the fall of the INR. By the way, he managed to suck up the rupee in circulation pro tanto, also curbing inflation. The RBI moves in the opposite direction when the INR appreciates too much against the dollar, thereby discouraging exports.

The Deputy Governor was right, but perhaps he was oversimplifying things.

INR is fully convertible on current account i.e. foreign trade of Indian residents can be conducted in any currency. But it is not fully convertible into capital account. Indian companies, however, benefit from partial capital account convertibility by being empowered to float their shares overseas through Global Depository Receipts (GDR) or its US equivalent ADR. An American can sell the GDRs on the BSE if he discovers that there is an arbitrage opportunity by converting the GDR into shares and being paid in INR.

When we embrace full convertibility, as the Deputy Governor of the RBI called for, anyone can pretty much do whatever they want. Suppose one has Rs 10 lakh in his savings bank account. She can ask her bank to hold Rs 5 lakh in INR and the rest in greenback, euro, Japanese yen or any other combination. The stranglehold of banks on the foreign exchange market would decrease.

Currently, Indian banks trading in forex enjoy huge spreads – sell a dollar for Rs 80 but buy the same dollar for Rs 84, in a tails I win, tails you lose fashion. The difference between the bid and ask rates is called the spread, which is Rs 4 in the given example. This would end because price discovery would be much better in an open and free market.

The concern could be that Indian residents are abandoning the INR in favor of the greenback. The main reason why the US dollar outperforms all currencies is its increased demand, thanks to its status as an international reserve currency. If this happened, the INR could be further mutilated.

So, the Indian government is right to take a calibrated approach to full capital account convertibility and not rush things by plunging headlong into full convertibility in a sudden blood rush.

In an atmosphere charged with religious emotion on the occasion of the upcoming Assembly elections, it is designed to appeal to the feelings and inclinations of voters but clearly has no economic justification.

The Chinese yuan has strengthened against the US dollar thanks to China’s phenomenal export earnings and FDI inflows. However, it is another matter whether the Chinese government has followed a conscious policy of undervaluing the yuan to incentivize exporters who get more domestic currency for every dollar exported.

If India wants the INR to be stronger, it needs to strengthen its economy as exports overtake imports and India becomes a manufacturing hub attracting huge FDI. That’s far from being the case. Therefore, it is a bit premature to float the INR. Especially since China has not yet taken the plunge.

Probably in addition to waiting for the Indian economy to strengthen, the Indian government should also wait for the end of the greenback’s lucky streak, which could occur when the nations of the world break free from dependence on the dollar. Incidentally, the greenback’s overvaluation may not be such a good thing for its exports.