Lessons from the Indian currency defence of 2013…

Prof. Ajay Shah reviews the various measures taken in India’s currency defence of 2013. He looks at the impact of these measures on various markets and says it only led to more volatility.

In 2013, the Indian government mounted a big defence of the rupee. The authorities appeared to throw everything that they could at the problem: enhanced capital controls on outflows, relaxed capital controls on inflows, exchange rate intervention, restrictive actions which damaged currency market liquidity to make it easier to manipulate the market by trading on the market, and monetary policy tightening. Seethis article for a narrative from that period, and a set of links to contemporaneous thinking.

It’s important to look back at this period and ask: Did the currency defence deliver on its objectives? Can we identify costs and benefits?

As with all episodes of currency defence, we do not observe the counterfactual: What would have happened if the authorities had not mounted this currency defence? In this case, we have some interesting evidence ahead which suggests that the outcome was not influenced by all these actions.

Along the way, we suffered collateral damage of numerous kinds. Many components of a currency defence are effectively an interest rate defence. At a difficult time in the economy, defending the rupee by raising rates hurt the domestic economy further.

In what follows, on each of the graphs, we superpose the dates of various kinds of actions taken by the authorities. This helps us conduct an intuitive causality test: if an action mattered, it should have yielded some impact in its immediate after math. These graphs also help us see through the claims made by authorities. (Event studies have valuein this broad area of research, but are problematic here as there is a lot of event clustering).

Lessons from the analysis:

  1. USD/INR seems to have responded to global events and all the actions of the authorities seem to have had little impact.
  2. The entire focus of economic policy in that period was on fighting the INR depreciation. Every day, new tools were being bandied about and implemented. There was a reverential approach to the power of central banks — currency intervention, capital controls, choking off financial markets, arranging lines of credit, etc. But when we look back, we see that the central bank was ineffectual in delivering on the goal.
  3. The cost of all the actions taken by the government was large, and the payoff obtained from the actions was elusive. Ex post, we see that the cost of mounting the defence was much larger than the costs envisaged at the outset by proponents of the currency defence.
  4. Mr. P. Chidambaram heard the views of many advisors, and chose to go with the folks who advocated a big muscular currency defence. A bad call.
  5. I feel that the academic literature on capital controls and currency policy does not adequately come to grips with the mess that we get in the real world when we try to do these things. It’s easy to bandy about capital controls or currency trading. Such `heterodox thinking’ has become fashionable. Capital controls are not irrelevant; they can deliver pricing distortions and reduce market efficiency. What’s important to ask is: Do capital controls deliver on the goals of macroeconomic policy? The answer in India seems to be: No.
  6. Some advisors at the time said that it was possible to `squeeze the shorts’ and `hit the speculators’ without contaminating monetary policy. But all currency policy is monetary policy, and all real monetary economists know this. Every currency defence becames an interest rate defence. The policy rate went up by 440 basis points, dealing a body blow to a weak economy. By August 2013, I felt the UPA was going to lose the next election.
  7. When the authorities defend the rupee, this protects foreign currency borrowers. In addition, raising rates hurts local currency borrowers.  This is different from the conventional moral hazard argument, that currency policy creates moral hazard in favour of more unhedged foreign currency borrowing. The new thing I understood in 2013 was that a currency defence is not only good for unhedged foreign currency borrowers; it hurts local currency borrowers. These two factors come together to shape the incentives of firms on choosing between borrowing in local currency vs. borrowing abroad. If you borrow in USD, you will get support from the government in extreme events; if you borrow in INR, you will get hit by the government in extreme events.
  8. Episodes like this interact with the bureaucratic politics of Indian finance. As an example, currency futures trading started in 2008, against the protests of RBI which feared the loss of turf (the role of SEBI on exchanges). RBI was also concerned about the possibility that exchanges might achieve liquidity and market efficiency, and thus undo decades of hard work in preventing a genuine currency market. The currency defence of 2013 was used as an opportunity to hamper the working of currency derivatives trading on exchanges. Even today — June 2015 — some of those restrictions imposed in the summer of 2013 have not been reversed.
  9. Market liquidity got worse once the currency defence got going. This may have implications for the decision to stay exposed through a currency defence.
  10. It takes a long time for the damage caused by a currency defence to heal. Some economists think you can switch off and switch on finance at a whim. But the working of the financial system is ultimately about the organisational capital in financial firms. When private firms want to build a business,  organisational capital can only be built slowly, and after such episodes, private firms may not feel like committing resources to build a business. Private firms lose respect and trust in the authorities when they see such episodes, and hold back from investing in building the business.

This is contrary to what one would expect. Congress politicians would not have intervened to lose elections. Further, the publicity these measures generated and created heroes (and villains), it is for sure that the intensity will only increase next time around. It is difficult for policymakers to not do anything during the crisis. You cannot say I will let the exchange rate go anywhere during an exchange rate crisis.

Even if this was limited to the crisis, it was fine. What has been difficult to understand is that how currency intervention has only only continued to increase. When RBI was buying forex reserves in the period 2005-8, it was heavily criticised as it did not confirm to the so called modern monetary economics where one had to give up forex targeting and only focus on interest rates, Now, we have moved to the modern monetary framework but continue to engage in policy which was termed draconian. Even worse, all this is being packaged as something new and something of a strength!

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