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Covered Interest Rate Parity
Second Tarapore panel `uncovers' little

A. Seshan

The second Tarapore Committee on Fuller Capital Account Convertibility (STC) cites the following recommendation of the first Tarapore Committee (FTC) of 1997: "The RBI should have a Monitoring Exchange Rate Band of +/- 5.0 per cent around the neutral REER. The RBI should ordinarily intervene as and when the REER is outside the band.

The RBI should ordinarily not intervene when the REER is within the band. The RBI could, however, use the judgment to intervene even within the band to obviate the speculative forces and unwarranted volatility. The Committee further recommends that the RBI should undertake a periodic review of the neutral REER which could be changed as warranted by fundamentals." The STC Reports says that "the present Committee endorses the recommendations of the 1997 Committee".

Covered Interest Rate Parity

In para 3.31, the FTC Report had said: "The move toward CAC would logically ensure that the forward premia in the forex market reflect interest rate differentials between overseas and domestic markets. The Committee recommends that as part of exchange rate management, greater attention should be focussed on ensuring that the forward exchange markets reflect interest rate differentials."

This is the Covered Interest Rate Parity (CIRP) theory. The Second Committee could have rendered better service by elaborating upon the recommendation and indicating how exactly this is to be achieved. Under the CIRP, there will be no advantage to borrow or lend in one country's asset market rather than that of another. If there is an advantage, then interest arbitrageurs will move the market toward parity (see Discussion Paper on "Exchange Rate Theory: A Review" by Pongsak Hoontrakul, Chulalongkorn University, Thailand, on the University's Web site).

When an asset market is taken into account, an interest parity condition, like its more famous cousin, the Purchasing Power Parity (PPP), follows the law of `one price' in the international sphere. Inflation, interest rate and exchange rate are mutually dependent under the CIRP rule.

The Indian Context

The textbook prerequisites for CIRP are:

There are sufficient funds for speculation available. That is, there are arbitrageurs with funds to drive the rates to the equilibrium position unconstrained by restrictions on international capital movements;

We need foreign exchange markets, spot or forward, with well-defined and well-publicised rates freely available to a group of informed traders who are committed to exploiting any profit opportunities that crop up; and

Transactions costs are low enough to be negligible (Exchange Rates and International Finance, Lawrence S. Copeland, Addison-Wesley, 1994).

The first condition presumes the possibility of movement of `hot' short-term capital across the nation's boundaries. The second condition implies the availability of real-time data on exchange rate movements. Forex traders in India have this facility.

On the third pre-requisite, one notes that the transaction costs of Indian banks are much higher than those of the foreign ones. Unlike the flat rate per transaction in the West, banks in India still have a percentage basis in relation to value for calculating the bank commission.

Thus the Bank-Fund Staff Federal Credit Union, the equivalent of an Indian cooperative credit society, charges a flat $25 for the electronic transfer of funds from the member's account to his bank in India, irrespective of whether the amount involved is $1,000 or $1 million. On the other hand, a public sector bank charges a commission of 0.125 per cent of the value and Rs 1,000 as cable charges. There is also the Service Tax of 12.25 per cent. Of course, there are inter-bank variations. It is also possible that the charges are decided on a different basis for forex trading. While the second and the third requisites can be taken care of, the first will constitute the real test.

Given the proclivity of the Indian authorities to be extra-cautious and the genius of civil servants to shackle every single forward step of liberalisation with a couple of backtracking restrictions, one may safely assume that it will not happen in India!

Another panel needed?

While releasing a publication on the History of the Reserve Bank of India, the Prime Minister, Dr Manmohan Singh, said there was merit in moving towards fuller capital account convertibility and that he would request the Finance Minister and the RBI to revisit the subject and come out with a roadmap based on current realities.

One wonders whether what he had in mind was really another committee going into the matter or just FM-RBI consultations based on the existing report but suitably updated for the policy developments in the last decade.

In the final analysis the preconditions and other aspects covered comprehensively in the first report will not really change.

Even the stages envisaged therein can be calibrated appropriately over a different time profile keeping in view the changes that have taken place and the fresh experience observed, especially the lessons from the East Asian financial crisis.

(The author is a former Officer-in-Charge of the Department of Economic Analysis and Policy, Reserve Bank of India, Mumbai.)

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