A Seminar by NIRC –ICAI on 10.08.2013.

Presentation by Mrs.M.Vedavalli

Rupee Impact on

Indian Architecture

Rupees Stability and Monetary Policy

The Preamble of the Reserve Bank of India Act describes the basic functions of the Reserve Bank as:

"...to regulate the issue of Bank Notes and keeping of reserves with a view to securing monetary stability in India and generally to operate the currency and credit system of the country to its advantage."

Financial stability has also become an objective since 2000

Monetary Policy was the first line of defence in a currency crisis.

IMPLEMENTATION/ TACTICS

IMPLEMENTATION/ TACTICS STRATEGYSTRATEGY

InstrumentsInstrumentsOperating objectives/

targets

Operating objectives/

targets

Intermediate targetsIndicators of goal variablesIndicators of policy stance

Intermediate targetsIndicators of goal variablesIndicators of policy stance

Final GoalsFinal Goals

1. Official interest rates2. Reserve requirements3. Market operations4. Direct controls.

1. Short term money market rates2. Bank reserves

1. Exchange Rates2. Longer-term interest rates3. Money/credit4. Asset prices5. Long-term growth

1. Price stability2. Long-term growth3. Financial Stability

The Monetary Policy

Monetary Policy in Globalised World

Impossible Trinity Trilemma

Simultaneous Maintenance of 3 Policy Goals not possible Free Capital FlowsFixed Exchange

RateIndependent

Monetary Policy

Monetary Policy in Globalised World

If Open Economy with Independent Monetary PolicyThen Drop Fixed Exchange Rate

If Exchange Rate is pegged then forego independent monetary policy

India’s PositionMiddle Path - giving up on some flexibility on

each of the variables to maximize overall macroeconomic advantage.

India’s Middle Path (i) Exchange rate largely market determined,

but intervention in the market to smooth excess volatility and/or to prevent disruptions to macroeconomic stability;

(ii) Capital account is only partly open; NO FCAC(iii) Because of the liberalization on the

exchange rate and capital account fronts, some monetary policy independence is forfeited.

Always vigilant on all the three fronts with emphasis shifting across the three pillars depending upon the macroeconomic environment.

Forex ReservesIn India, foreign

exchange reserves are defined as external assets which are readily available to & controlled by RBI for meeting BoP financing needs, for intervention in exchange markets to contain the volatility of exchange rate of the rupee and for other related purposes.

Forex Reserves contd…. At present, reserves include

foreign currency assets of the RBI, gold, SDRs & Reserve Tranche Position in the IMF which conforms to international best practices as suggested in the IMF manual.

Since 1993, the RBI has intervened in the forex market to keep an orderly movement in the value of the rupee. This approach kept the economy on track, but now the volatility in rupee movement threatens its derailment.

Table 1: Sources of Variation in Foreign Exchange Reserves* (US $ billion)

Items April-March

2011-12

April-March

2012-13 I. Current Account Balance -78.2 -88.2 II. Capital Account (net) (a to f) 65.4 92.0 a. Foreign Investment (i+ii) 39.2 46.7 (i) Foreign Direct Investment 22.1 19.8 (ii) Portfolio Investment 17.2 26.9 Of which: FIIs 16.8 27.6 ADRs/GDRs 0.6 0.2 b. External Commercial Borrowings 10.3 8.5 c. Banking Capital 16.2 16.6 of which: NRI Deposits 11.9 14.8 d. Short-Term Trade Credit 6.7 21.7 e. External Assistance 2.3 1.0 f. Other Items in Capital Account -9.4 -2.4 III. Valuation Change 2.4 -6.2 Total (I+II+III) @ -10.4 -2.4 *: Based on old format of BoP @: Difference, if any, is due to rounding off. Note: (i) ‘Other items in capital account’ apart from ‘Errors and Omissions’ include SDR allocations, leads and lags in exports, funds held abroad, advances received pending issue of shares under FDI and transactions of capital receipts not included elsewhere. (ii) Increase in reserves (+) / Decrease in reserves (-).

During 2012-13, there was a decline in the foreign exchange reserves. The sources of variation in the foreign exchange reserves are set out in Table below.

Table 2: Comparative Position of Variation in Reserves (US$ billion)

Items April-March

2011-12

April-March

2012-13 1. Change in Foreign Exchange Reserves (Including Valuation Effects) -10.4 -2.4 2. Valuation Effects (Gain (+)/Loss (-)) 2.4 -6.2 3. Change in Foreign Exchange Reserves on BoP basis (i.e., Excluding Valuation

Effects) -12.8 3.8

4. Percentage of increase/decline in Reserves explained by Valuation Gain/Loss -23.1 262.7 Note: Increase in reserves (+)/Decrease in reserves (-). Difference, if any, is due to rounding off.

On a balance of payments basis (i.e., excluding valuation effects), the foreign exchange reserves increased by US$ 3.8 billion during 2012-13 as against a decline of US$ 12.8 billion during 2011-12. The foreign exchange reserves in nominal terms (including the valuation effects) declined by US$ 2.4 billion during 2012-13 as compared to a  decline of US$ 10.4 billion during the previous year .

Introduction : Journey of E.C.

Phases of EC EC has been in

existence since 2009

These 7 decades can be divided into distinct three phases.

Structural Reforms initiatedAnnouncement of New Industrial Policy 1990.Adoption of floating exchange rates based on market

forces, i.e. demand and supply (LERMS / U-LERMS).Liberalisation and simplification of the procedure /

documentation.Delegation of powers to Authorised Dealers.Amendment to F.E.R. Act, 1973 in 1993.Adoption of article VIII of IMF accepting full

convertibility of current account w.e.f. 20.08.1994.Constitution of Committee on Capital Account

Convertibility in 1997.Replacement of FERA, 1973 by FEMA, 1999FCAC 2006

Forex Transactions Capital account transaction”

means a transaction which alters the assets or liabilities, including contingent liabilities, outside India of persons resident in India or assets or liabilities in India of persons resident outside India

Underlying principle – current account transactions which are not restricted are permitted (negative list); whereas capital account regulations indicate the transactions which are permitted (positive list)

Current account transactions

Govt. by rules notified under Sec.5 of FEMA, 1999.

Categorized in three schedules –Sch. I- prohibited items (8)Sch. II- subject to Govt. approval (10)Sch. III- subject to RBI approval (13)

All current a/c. transactions are undertaken by APs under delegated powers.

Capital account transactions Governed by regulations

notified by RBI in consultation with GoI.

Separate regulations for investments, borrowings, lending, deposits, export and import of currency, guarantees, surrender of foreign exchange, foreign currency accounts, remittance of assets, immovable property, derivative contracts, etc

Most of the transactions could be undertaken under the general permission

Need for Rules and Regulations

India is not fully convertible on Capital account.

The indicative limits on few current account transactions are designed for restricting capital transfers through current account.

Regulating the forex market.Realisation & repatriation of

export proceeds and surrender of forex earnings are mandatory.

One of the counter party to any forex transactions should be an AP, licensed by RBI.

Capital account convertibility- Approach

It is a process not an event.Gradual implementation.Guided by FCAC Report and consistent with

macro-economic and global developments and ability to meet concomitants.

Cautious implementation to avoid back-tracking.Extremely cautious about two areas-

• Unlimited access to short term external commercial borrowings for meeting working capital and other domestic requirements.

• Providing unrestricted freedom to domestic residents to convert their domestic bank deposits and idle assets such as real estate in response to market developments or exchange rate expectations.

Lessons from Country Experiences

Even under fully convertible environment, prudential safeguards are necessary to insulate the economies from potential capital account crises

Gradual approach to liberalization is being used as a tool for furtherance of sound macro-economic and prudential policies

Exchange rate flexibility is important while undertaking capital account convertibility

Lessons from Country Experiences

Liberalization can be beneficial when countries move in tandem with strong macroeconomic policies, sound financial systems and markets, supplemented by prudential regulations and robust supervisory framework, accounting and disclosure standards

Emerging markets which failed to mitigate the flows through sterilization had to re-impose capital controls (recent examples of Thailand, Colombia, Brazil, etc) or backtracked

Active capital account management

A variety of measures to manage the flows for reducing overheating, currency appreciation and vulnerability to sharp reversal of flows

Monetary policy measuresPrudential measuresCapital control measures and

liberalization of outflows

Issues and challengesThe risks of CAC, trigger

from inadequate preparedness in terms of prudential regulation and supervision, development of markets, instruments for risk transfer, copious capital flows, sudden reversal of flows

Actual implementation should be dictated by macroeconomic conditions, unusual events

Large capital flows and sudden reversals have warranted a revisit to the policy of liberalization

Asymmetry in policy related issues- fiscal, markets, etc

How Capital Flows?Capital flows – not steady but

volatile. Respond to both push and pull

factors. Push factors the monetary

stance of advanced economy central banks - determines the liquidity in the global system

the need of global investors for asset diversification. Pull factors : Promise of growth in Emerging Economies, their stable and credible policy environments and improved governance.

Adequacy of Reserves

To gauge the ability to absorb external shocks

Traditional approach - in terms of import cover

Size, composition and risk profiles of various types of capital flows

Types of external shocks to which the economy is vulnerable

Adequacy of Reserves

Usable foreign exchange reserves >scheduled amortisation of foreign currency debts (assuming no rollovers) during the following year

"Liquidity at Risk" rule that takes into account the foreseeable risks that a country could face.

Global Financial Crisis• Sub- Prime Crisis in USA. Collapse

of the leading US investment banks in August-September 2008.

• Problem of contagion – across markets, across institutions and across countries.

• Risk aversion, deleveraging and frozen money markets – Increase in the cost of funds

• Lesson: Irrespective of the degree of globalisation of a country and the soundness of its domestic policies, a financial crisis could spread to every economy.De Coupling Theory proved wrong

Impact of Financial Crisis in Indian Real Sector

Moderation in growth in the second half of 2008-09 in comparison with the robust growth performance in the preceding five years (8.8 % p.a)

Negative growth in industrial output in Q4 of 2008-09 – a decline for the first time since the mid-1990s.

Erosion of external demand affected industrial performance

Crisis Impinging on Monetary Policy

Unprecedented international transmission of liquidity shocks

Falling asset prices -uncertainty about valuation of the traded instruments affected market liquidity

Failure of leading global financial institutions and the deleveraging process tightened the market for funding liquidity.

Growing risk of illiquidity cascading into solvency problems- credit and quantitative easing acquired priority in most central banks.

Action TakenThe contagion warranted swift

monetary and fiscal policy responses to ensure

1. orderly functioning of markets, 2. preserving financial stability,3. Moderating its adverse effects on

growth.  Measures taken for improving

domestic and foreign currency liquidity through rate cuts, CRR cut, additional liquidity support, Easing of ECB norms, relaxing interest rate ceiling on forex deposits, borrowing norms for banks, loans to mutual funds, introduction of currency futures, FCEBs etc.

Aftermath of Crisis

Quantitative easing policies of advanced economy central banks.

Global system awash with liquidity. Capital flown into EMEs, posing the familiar

problem of capital surges. The tail risks to global recovery had eased in

the early part of the year.

Impact

Changes in the Reserve Bank’s policy rates were quickly transmitted to the money and debt markets.

Transmission to the credit market was slow due to several structural rigidities in the system, especially the dominance of fixed term deposit liabilities in banks’ balance sheets at fixed interest rates.

Growth V/s Inflation Dynamics

Monetary policy stance over the last two years has predominantly been shaped by the growth-inflation dynamics, even as external sector concerns have had a growing influence on policy calibration over the last one year.

The current situation – moderating wholesale price inflation, prospects of softening of food inflation consequent on a robust monsoon, and decelerating growth – would have provided a reasonable case for continuing on the easing stance.

Bernanke’s Announcement Effect

Flash turmoil in the financial markets in late May because of the ‘announcement effect’ of the tapering of quantitative easing (QE) by the US Fed

Market expectations of QE taper and the consequent increase in real interest rates in the US have translated into a rapid appreciation of the US dollar and consequent depreciation of EDE currencies.

Commodity prices generally softened, but the price of crude remains elevated.

Indian SceneRisks to growth increased notwithstanding the robust

onset and spread of the monsoon. Industrial production slumped, with lead indications

of declining order books and input price pressures building on rupee depreciation. services sector activity is also subdued in part because of adverse spillovers from tepid recovery around the world.

Export performance undermined, even as heightened volatility in capital flows has raised external funding risks.

Outflows of portfolio investment particularly from the debt segment. Ensuing exchange market volatility.

Wholesale price inflation pressures are on the ebb, but retail inflation remains high.

CAD worrying FactorRupee dollar rate touched a record low of

Rs.61.5355 on August 6, 2013 as compared to Rs.54.2415 as on May 9, 2013.

The CAD moderated to 3.6 per cent of GDP in Q4 of 2012-13, down from 6.5 per cent in Q3, due to narrowing of the trade deficit. However, for 2012-13 as a whole, the CAD was 4.8 per cent of GDP, well above the sustainable level of 2.5 per cent of GDP.

In the current year, the trade deficit widened during Q1 over its level a year ago, mainly on account of deteriorating export performance. Financing came by way of higher FDI, net ECBs and accretion to non-resident deposits, with some use of reserves.

Measures Initiated by RBI & GOI

June 4 : To curb import demand, import of gold on consignment basis was restricted on June 4

June 5: customs duty was raised July 8 : Banks restricted to trade only on behalf

of their clients in currency futures/options markets, exposure norms tightened, Margins on currency derivatives raised to check speculative activities.

July 15: MSF rate raised by 200 bps to 10.25 per cent, overall access by way of repos under the LAF restricted to Rs.750 billion.

RBI MeasuresJuly 18, 2013: Dedicated Special Repo window for

a notified amount of Rs. 250 billion for liquidity support to mutual funds to tide over redemption problem.

July 22, 2013: All nominated banks/entities to ensure that at least one fifth of imported gold is exclusively made available for the purpose of exports. Any import of gold under any type of scheme will have to follow this 20/80 formula. Consequent to this, the earlier instructions banning the import of gold on consignment basis were withdrawn.

RBI MeasuresJuly 23, 2013 : Access to LAF by way of repos at

each individual bank level restricted to 0.5 per cent of the bank’s own NDTL effective July 24, 2013.

The cash reserve ratio (CRR), which banks have to maintain on a fortnightly average basis subject to a daily minimum requirement of 70 per cent, was modified to require banks to maintain a daily minimum of 99 per cent of the requirement.

August 8, 2013: RBI will auction Government of India Cash Management Bills for a notified amount of Rs. 22,000 crore once every week on Mondays.

Impact on Economy

Impact on Economy Growth projection for 2013-14 is revised downwards from 5.7

per cent to 5.5 per cent.Sharp depreciation of the rupee since mid-May is expected to

pass through in the months ahead to domestic fuel inflation as well as to non-food manufactured products inflation through its import content. Price of Imported coal goes up leading to power tariff increase which in turn will impact the common man. Supply constraints in food and infrastructure fuelling inflation.

It comes down to the common man, it leads to inflationary trends, and therefore it also affects the interest rates.

CAD > sustainable level for 3 years in row. External vulnerability indicators have deteriorated. Economy’s resilience to external shocks is eroded and structural reforms required.

Increase in resources raised by commercial sector from domestic banks and from abroad, especially through external commercial borrowings (ECBs) and foreign direct investment (FDI).

Reserve Bank’s Stance

The four broad contours of monetary policy stance are: 1. to address the risks to macroeconomic stability from

external shocks;2. to continue to address the heightened risks to

growth;3. to guard against re-emergence of inflation

pressures; and4. to manage liquidity conditions to ensure adequate

credit flow to the productive sectors of the economy.

RBI’s GuidanceThe recent liquidity

tightening measures by the Reserve Bank are aimed at checking undue volatility in the foreign exchange market and will be rolled back in a calibrated manner as stability is restored to the foreign exchange market.

THANK YOU!!!!