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

2. 2 Exchange Rates

3. 3 Exchange 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. 4 Exchange 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. 5 Exchange 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. 6 Exchange 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. 7 Exchange 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. 8 Exchange 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. 9 Exchange 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. 10 Exchange 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. 11 Exchange 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. 12 Exchange Rates LAS AD

13. 13 Exchange 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?