Indian Rupee and Economic Reforms

Sushil Khanna


For the last few months, the value of the Indian rupee has been under pressure in the financial markets. After having been stable for more than a year, it began its downward march in May 2000, destabilizing the economy and raising the spectre of another balance of payments crisis and rising interest rates.


In order to understand the dynamics of this emerging crisis, it is important to appreciate how our government and its advisers, including the Reserve Bank of India, in their eagerness to open up the economy, have mortgaged our economy to international capital.


The roots of the problem lie in the mindless liberalisation of the financial sector and the external sector simultaneously. Instead of focusing on stability and policies that would support growth and production, the growth of financial sector itself emerged as an objective in the 1990s.


Remember, the Narasimham Committee had told us that the financial sector reforms would make the Indian financial system more efficient and bring down the interest rates. The government, we were told, will stop forcing the banks to lend it cheap capital under the garb of Statutory Liquidity Ratio (SLR). Capital will be cheaper and investment large, with foreigners also investing in the new Asian El Dorado’s.


The experience of the 90s has belied this claim.  Real interest rates have been at their historical peak marking a break from the earlier regime.  All this is not due to the fact that the government was shy to lower rates on provident fund deposits (which it has done). It was due to the financial reforms and conscious efforts to integrate domestic money markets with the global capital markets through capital account liberalization. An additional factor was the increasing interest burden on the Central government as it moved to market determined rates to meet its borrowing requirements from the banking sector.


Since the mid-1990s, India moved to a free convertibility on the current account, i.e., for import and export and other current payments and transfers, all traders could buy and sell dollars (and other currencies) without Reserve Bank’s permission. This we were told by advocates of the reforms, would help Indian rupee finds its true value and also help the exporters. If imports became too large compared to our exports, rupee will depreciate, raising the cost of imports and making exports more profitable. This will ultimately help to reduce the trade deficit and bring stability to our balance of payments position.

In addition, the government in its wisdom opened up the Indian capital and stock markets to foreign investors in 1993. Foreign Institutional Investors (FIIs) thus entered India in hordes bringing in large amounts of capital. So large was the inflow of foreign capital that the Reserve Bank was forced to buy dollars from the foreign exchange market to prevent the rupee from appreciating.


Very soon the FIIs began to call the shots in the Indian stock exchanges. Given the fact that their decision to invest or dis-invest is guided by global interest rates and their perception of political stability in India, as well as the pace of opening up the Indian economy and specific sectors like insurance. Today, if the interest rates in USA or Europe rise, many FIIs reallocate their funds to the Indian market. Thus the stock prices in India today no longer reflect the economic conditions in India, but are guided more and more by interest rate differentials between India and global markets. premature liberalisation of financial markets and the capital account.


One must keep in mind that the Indian foreign exchange market is very thin. India’s average exports per day are less than $100 million. Minor

The liberalisation programme also reduced the amount banks were forced to lend to the Central Government under SLR (Statutory Liquidity Ratio) from about 40% of their deposits to less than 25%. But this does not mean that the Central Government has reduced its borrowing from the banking sector. On the contrary, the borrowing increased as the government reduced the taxes on income of the rich and corporate sector and also reduced custom duties under pressure from the WTO. However, the government failed to raise new resources and while it was reducing its expenditure and support to the social sector and subsidies to the poor it was increasing the expenditure on arms and nuclear programme. Hence Government continued to be a large borrower from the banking sector. In recent times the government has tried to open up the market for government bonds to foreign institutional investors. All this has meant that the one of the factors keeping interest rates high was the government’s own borrowing and its decision under advice from its Washington friends to borrow at market rates.


Interest Rates and Rupee Value


A brief history of RBI’s monetary stance over the Nineties may be illuminating. When the country ran into a balance of payments problem in 1991, the RBI raised interest rates and tightened credit to stem the inflationary pressure and rein in the demand in the economy in the belief that that deflation was necessary. Even if one differs on the cause of the crisis of 1991, as an intervention to stabilise the economy while the government scrounged around for international borrowings and pawned its gold reserve, this was inevitable and acceptable. What is intriguing is the fact that this regime of high interest rates lasted so long that is most of nineties.

To most observers, it was obvious that the high interest rates have hurt growth and corporate restructuring. Yet the RBI failed to nudge the rates lower for almost another five years and if our analysis is correct, the current regime of lower interest rates is already over! The answer to the riddle lies squarely in the rapid and perhaps changes in the demand for dollars or marginally increase in inflows (or outflows) by FIIs leads to large fluctuations in the value of rupee, forcing RBI to either buy or sell dollars. Over the 1993-98 period, RBI has thus accumulated about $ 25 bn. This means that the market is not able to set a price for rupee without RBI intervention.


Let us go back to 1993-94. Interest rates were all time high with prime rates near 19 percent. Inflation was moderate (about 7-8 percent) and balance of payments comfortable with reserves in the region of $18-19 billion. Indian firms had tested the market for foreign funds through the GDRs.  The then RBI governor, Dr. Rangarajan felt confident enough to further liberalise the capital account by permitting FIIs to invest in the Indian stock market.  Soon, exporters were granted freedom to retain funds abroad and so were corporates with GDR funds.


The freedom was given to exporters to retain funds abroad for as long as 180 days, thus converting current receipts into capital investment from the country. Simultaneously the interest rates in the domestic market were deregulated. These two acts immediately converted all exporters into speculators who would compare the domestic interest rates with the interest abroad and the future price of dollars, the more attractive option of the two being usually selected. The exporters always look to domestic interest rates as an incentive to repatriate their dollars. Any lowering of the interest rates in the domestic market or reduction in the differential between Indian interest rates and those in the global markets, reduces the incentive to exporters to bring the dollars back to India.