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May 23, 2012: The rupee has become highly volatile and it has crossed 56 a dollar despite the

intervention from the Reserve Bank. The stability of the rupee has been a hotly debated topic for quite some time as the fundamentals of the economy have been very much disturbed due to the failure of the Government in managing the economy with the reforms it badly deserves in the context of deteriorating external economic scenario and domestic economic environment.

The issue of how to tackle the sharp fall in the exchange rate and save the rupee and the economy has come to the fore, with the Finance Ministry and the RBI expressing optimism and confidence that the situation can be managed without the backing of any convincing measures to improve the fundamentals of the economy. The Foreign Exchange Reserves which stood at US $ 309.72 billion in March 2008, peaked at US$ 328.98 billion in August 2011 and came down sharply to US$294.39 billion in March 2012. This has been dwindling since then due to frequent intervention by the Reserve Bank in the forex market to contain the depreciation of the rupee. According to the Reserve Bank 'The balance of payments (BoP) came under significant stress in Q3 of 201112. Net capital inflows fell short of the current account deficit (CAD), resulting in a substantial drawdown of reserves. A wider CAD, rising external debt, weakening net international investment position (NIIP) and deteriorating vulnerability indicators underscore the need for greater prudence in external sector and demand management policies. While capital inflows have improved in Q4, global uncertainties, moderation in the economic growth of emerging and developing economies (EDEs), which now have a significant share in Indias exports and persistently high oil prices generate downside risks to the external outlook'. RBI Bulletin May 2012).

In response to the series of measures initiated by the Reserve Bank FII inflows picked up significantly, in both equity and debt, in January and February. While FDI inflows remained broadly stable, the ECB inflows also improved a lot. The rupee which depreciated sharply against the US dollar from the last week of August 2011 to mid-December 2011, recovered and stabilised for some time as a result of the measures undertaken by the Reserve Bank and the government at improving dollar supply in the foreign exchange market as also to curb speculation. The cumulative impact of these measures considerably reversed the movement of the rupee against the US dollar from the historical low of `54.2 per US dollar on December 15, 2011 to `49.7 per US dollar by endJanuary 2012. However, the rupee weakened subsequently and crossed ` 56 a dollar on May 23. As per RBI's own admission, the key external sector

vulnerability indicators have been worsening over a period. The reserve cover of imports, the ratio of short-term debt to total external debt, the ratio of foreign exchange reserves to total debt, and the debt service ratio got deteriorated over a period.

The Current account Deficit which was only 2.3 % of GDP in quarter 3 of 201011 crossed 4.3% of GDP in quater 3 of 2011-12 and continues to rise unabated. As long as the high level of international prices of oil remain, as also the consumption of oil, which has been on the increase and the pricing pattern for the same presently adopted continue to be politically sensitive and economically non viable , the position of BOP, exchange rate, fiscal deficit and current account deficit etc cannot be expected to show any considerable improvement in the near future. The external environment with the Greek and other European economy in crisis also does not offer any consolation to expect a favourable position to improve the trade and increase in inflows of foreign exchange. The FDI and FII flows can be augmented only if the fundamentals of the economy and the overall confidence in the management of the economy can be established through the process of reforms in different areas like administration, taxation, legal and infrastructure development particularly in the power sector which is unfortunately not taking place.

The present critical situation merits the consideration of calls for an abnormal solution. In this context, it is ideal to set up a Foreign Exchange Rate Stabilisation Fund, to contain and prevent the frequent volatility of the rupee and its adverse consequences on the economy. The Government's recent white paper on black money has hinted at an amnesty scheme for assets secretly amassed abroad. These funds can be mobilised under the nomenclature Foreign Exchange Rate Stabilisation Fund and can be maintained with the Reserve Bank on behalf of the Government. It is best and the most opportune time for the Government to finalise the amnesty scheme expeditiously though it may perhaps involve loss of revenue and forbearance in taking penal measures. Although, the white paper is silent on the quantum of such money, the amount if permitted to bring in officially, would be huge sum and beyond the imagination of the Govt, as it may help to avoid the other routes like PNs and FDIs now suspected to route the black money to India.

To neutralize the impact of purchase/sale of foreign exchange and consequent money supply and liquidity in the market, normally sterilization is done using government securities for sale/purchase. The whole exercise involves a cost and creates an element of uncertainty and speculation in different markets in

the financial system. These can be to a great extent minimized if the foreign exchange mobilised under the Exchange Rate Stabilisation Fund is allowed to be retained as such without involving rupee exchange. For the contributor towards this fund, this can facilitate as a deposit account that can be withdrawn on demand of course after running a specified period subject to the terms and conditions prescribed under the amnesty scheme.

The main advantage of such a fund would be that it would attract inflows, eliminate instant rupee supply and the consequent ripple effects. The cost involved in creating such a fund and the disadvantages if any perhaps faced by those who contribute to this fund will more than offset the problems and costs now faced by the economy because of shortage of foreign exchange and adverse chain effects. This fund can be utilized for exclusive development of infrastructure requiring foreign exchange.

This solution may initially appear to be irrational but may prove to be a boon in the long run for all stakeholders particularly the government and the economy. The Govt can also keep this fund open to those who have surplus forex resources and are willing to contribute for some incentives.

This fund can be akin to the India Development Fund where deposits were received for a specified period. The contributors to the fund( other than those who bring funds under the amnesty scheme) now being suggested can be compensated by way of interest or some incentive or both in rupee terms. Exchange rate risk at the time of return of the funds on demand or on maturity can be hedged through derivatives. This will also activate and strengthen derivatives market. The funds accumulated can be made available to utilize exclusively in forex for development of infrastructure by way of import of technology, skilled manpower, materials research and development.

The setting up of such a fund, without involving rupee exchange, initially appears to be conceptually difficult but, it cannot be ruled out as impossible. It is like Security Transaction Tax which was initially objected to but has come to stay fetching good revenue to the Government and without inflationary implications as the levies cannot be passed on to general consumers as happens in the case of VAT and other levies.

The costs involved in developing , maintaining and managing such a fund may turn out to be highly beneficial when compared to the present crisis, costs and risks involved to contain the volatility of the rupee, maintain financial stability, favourable inflationary conditions and the credibility among the international community to continue to attract investments in India.

(The author is a Mumbai-based consultant)