The RBI governor's utterances at a press briefing on Monday have not gone down well with the forex market. The rupee fell to 39.93 to the dollar on Tuesday before correcting on massive RBI intervention. Dealers point to the contradiction between being "satisfied" about a particular exchange rate and not undertaking to defend it. It is also confusing that although the erstwhile RBI governor felt that 37.50 is the correct rate for the rupee, the present incumbent believes that 39.50 is satisfactory.

Statements such as these only give the impression that the RBI does not know what it is talking about. If the intention is to peg the value of the rupee at a particular level it could announce a broad price range, and then intervene massively to defend the level. The Indian forex markets are thin and relatively closed, and the RBI has enough weapons in its armoury to impose its view on the market-at least for a time, and provided the level is not too far removed from the "fundamentals."

The RBI governor has also said that he is only interested in smoothing volatility, leaving himself open to the interpretation that the RBI will acquiesce in a slow but steady fall of the rupee. On the other hand, dealers also say that the RBI is likely to strongly defend the rupee at 40. In situations like this, when the central bank gives contradictory signals, the market is left pretty much to its own devices. What happens then is that the prevalent trend becomes self-reinforcing. For example, it was the inter-bank market which forced the rupee down on Tuesday morning. Almost everyone, in the words of one forex dealer, is long on the dollar, or wants to be long on the dollar or wishes he had been long on the dollar. Some corporates say that the RBI bidding the dollar down is good news, as they will then be able to buy it cheaper.

In the final analysis, everything boils down to a question of confidence. Near-term flows of money are not very encouraging. ECB flows have dried up, and portfolio funds are leaving the country. There have been hefty devaluations in our neighbourhood and a perception has gathered ground that the rupee needs to be devalued in order to keep the country competitive.

These were the factors which triggered the rupee fall, helped by RBI pronouncements on the overvaluation of the rupee. Under these circumstances, once a trend develops, corporates who hadn't covered start panicking. It is here that the central bank needs to step in and restore confidence. Unless that happens, the free fall will continue. But for the central bank to restore confidence, its own actions must be credible in the eyes of the market. Credibility is tough to maintain-somewhat like the emperor's new clothes. So long as everyone thinks that the emperor is clothed, everything's fine. But it only takes one little boy to point out that the emperor has no clothes for confidence to collapse. Unfortunately, the market is fast believing that the RBI has no clothes at all.

There is a perception that it is the banks who have taken advantage of the free fall to speculate. But banks are the most regulated of all sectors-the RBI knows exactly what the bank positions are, and can take corrective actions whenever the need arises. What the RBI does not know is about the intentions of corporates-the only way to influence that expectation is to raise the level of confidence. This will have the effect of converting the vicious circle of rupee depreciation feeding off panic into a virtuous one of higher confidence levels leading to exporters bringing money in and importers refraining from rushing for cover. Add to that the likelihood of foreign portfolio inflows picking up once the rupee depreciation stops, and there is every possibility that RBI intervention will have to be short and sharp, but temporary.

The market feels that RBI needs to be far more market-savvy. But there is a fundamental problem here -- the central bank is staffed by people who have little experience in manipulating the markets. They have a whole army of economists, who can calculate arcane and perfectly useless real effective exchange rates at the drop of a hat, but who often do not know a single forex dealer or corporate treasurer. What the RBI needs is fresh blood-it should recruit people who know the market. Central bankers abroad, for example, are frequently recruited from commercial bankers, who work at the central bank for some years. Their experience of the commercial world is often invaluable. Economists have their uses, but for calming the markets you require a psychologist.

The problem is that the credibility problem of the RBI can only grow, with freer markets. At present the Indian forex markets can be bludgeoned into submission, but with capital account convertibility, such measures will not work. As Subir Biswas of ABN Amro points out, "At present, the RBI can force the market to believe in its credibility. When the markets become free credibility will have to be earned."

Copyright © 1997 Indian Express Newspapers (Bombay) Ltd.