MUMBAI, Dec 25: The Reserve Bank of India (RBI) has rejected the SS Tarapore-headed capital account convertibility panel's recommendation for an exchange rate band. The central bank, in its Report on Currency and Finance, 1996-97, has said that such a band "would be inappropriate on credibility grounds".

Says the report in its argument against the framing of such a band: "A band could be arrived at by constructing a panel of real effective exchange rate (REER) indicators, each representing adjustment of effective nominal exchange rate movements for changes in relative prices, productivity differentials, prices of tradables and non-tradables in prices of financial assets, tariff and non-tariff reforms, improvements in payment and settlement systems affecting transaction costs.

"It needs to be recognised that in view of the difficulties associated with construction of several REER indicators, the central bank's intervention strategy should primarily be to ensure an orderly exchange-rate market condition by containing excessive volatility. Movements in the REER, which take into consideration developments in the trade account alone may not be representative of fundamentals."

At the same time, the report emphasises that the conduct of the exchange-rate policy must not be primarily guided by the developments in the capital account of the balance of payments.

The Tarapore-headed CAC had recommended a +/- 5 per cent band centered around a neutral REER. Such a band was to serve as a guide to policy, identification of a neutral base and the exact lag structure indicating the response of trade flows to REER movements.

The Reserve Bank has argued that setting up a +/- 5 per cent band suggests a rolling neutral REER for comparing REER for any period.

"Such a crawling band in which the central level of the exchange rate would alter depending on the lag length and a moving base describing a locus of sustainable external balance positions would have several advantages, particularly in terms of anchoring expectations. The success of the suggested band, however, would be contigent upon the attainment of all the preconditions on a sustained basis. In the face of large destabilising capital flows and/or periodic deviations from norms suggested as preconditions (by the CAC), rigid pursuance of such a band could, however, be costly and distortive, says the report.

Highlighting the developments on the exchange rate front, the report said the rupee remained reasonably stable in 1996-97 being traded in a narrow range of 35 to 35 against the dollar between May 1996 and June 1997.

The resurgence of capital inflows in the absence of any widening of the current account deficit necessitated intervention purchases of $7,801 million by the RBI in 1996-97. The real exchange rate --in terms of trade based real effective exchange rate--continued to appreciate during the year, rising by 6.4 per cent by March 1997, it said.

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.