Tiger By The Tail

The men running India's economy are obviously familiar with the work of Robert Lucas, this year's winner of the Nobel Prize for Economics. But they appear to have paid no heed to it when they decided to stop keeping the rupee shored up at an unrealistic Rs 31.37. The Finance Ministry and the Reserve Bank of India (RBI) obviously felt that the rupee would fall to between Rs 34.50 and Rs 35, and stay there. These calculations were based on available data and experience, that is, the past behaviour of the markets.

Lucas' theory of "rational expectations", however, clearly shows that this is a half-baked approach to policy-making. Economic decisions should also take into account marketplace expectations generated by the data at hand. An example: a Government, six months away from parliamentary elections, wants to cut inflation. It raises interest rates, clamps down on money supply. Money thus becomes dearer and scarcer, so prices come down to meet available liquidity levels, inflation ends. QED.

Not quite, says Lucas. If the market believes that the Government does not mean what it says (that is, the market believes that the Government will not curb its own wastage and will print more notes so it can blow some more money on undeserving causes), all players will continue to expect – and demand – high returns on their money, so corporates will not curb prices, unions will continue to negotiate hard for wage hikes (because they believe inflation will keep rising), and the policy will fail.

Similarly, the moment the RBI stopped the rupee-buttressing operation, market forces took over in all their heartless opportunism, and with a staunch belief, right or wrong, that the fundamentals of the Indian economy are not strong. It was only on October 30 that someone in the Government suddenly remembered Lucas. Since then, there has been at least one statement a day from various Government and RBI functionaries. The litany: "The economic fundamentals are strong." The RBI made it more attractive for banks to chase non-resident Indian (NRI) deposits.

Though gutsy declarations hardly change the fundamentals of an economy, and changes in the NRI deposit scheme are at best peripheral tinkering, they did send out the clear signal that the Government would not shy away from some serious market intervention. Expectations changed, the rupee stabilised somewhat.

But expectations have not changed enough. The call money – short-term inter-corporate loans – market went berserk. The Government continues to borrow at irresponsible levels. Banks have to now pay up the third instalment on Government of India 2005 loans; the Rs 1,500-crore state government loans have to be subscribed to; outstanding ad hoc treasury bills have crossed the Rs 9,000-crore limit fixed in the MoU signed between the Government and the RBI. Net result: there's hardly any money left in the system for industry.

As call rates shot up to an unprecedented 85 per cent, players with some dollars lying around quickly sold against cash, lent the money out at exorbitant rates for a day and simultaneously bought dollars in the spot market (payment due two days later), sold these dollars as soon as they got them, and lent out in the call money market again. The opportunity for this happy profiteering came from the fact that the rate at which the dollar was now expected to rise against the rupee was lower than the speed at which call money rates were going up.

Meanwhile, the RBI and the State Bank of India (SBI) were playing tandem-tightrope-walk. While the SBI needs to buy dollars for foreign-debt and defence payments, the RBI has to ensure that these purchases don't send the rupee into free fall again, by selling small amounts cautiously at the right moments.

As trading ended on Friday, November 3, the RBI had still not gathered up the courage needed to dip into the country's foreign reserves, sell a billion dollars and plough that money back into the market. Nor had the Government made any dramaatic announcement that it was tightening its belt. The first would have been a calculated gamble, based on the assumption that this would not cause a flight of "hot money" from the country and deplete the reserves dangerously. The second would be an admirable act of political will. But, as Lucas has shown, the Government does not even have to actually cut its spend. It just has to announce its intentions credibly enough for the cynicism about the future to soften. And let rational expectations take over.