Over the past three months, the rupee has recovered much of the ground that it lost in its precipitous fall to 57.16 to the dollar in July this year. Indeed, the rupee has seen a greater increase in value than any other Asian currency in recent weeks. Steady inflows from foreign institutional investors (FIIs), courted by the government to keep the capital markets happy, have let the currency steadily appreciate. As it does, the question must be asked: how much appreciation should the Reserve Bank of India (RBI) be comfortable with? At what point should it step in and intervene? It should not be left too late, surely, or the mistakes of 2007 and 2010 will be repeated.
The RBI is not a single-issue bank, with a laser focus on inflation, as some might want it to be. Nor should it be such, for a certain amount of active, prudent management is essential to maintain macroeconomic stability in an economy as vulnerable as India’s. In this case, it is clear that the current account deficit is at levels that are, while not yet likely to cause a crisis, certainly enough that observers should worry. In the June quarter, the current account deficit was at 3.9 per cent — a fall, certainly, from the March quarter level of 4.5 per cent, but hardly in any sort of safe zone. This is all the worse since the primary cause of the expansion of the current account deficit in recent years is a fall in savings. Meanwhile, foreign exchange reserves have stayed below $300 billion consistently (according to the last full data release by the RBI, in the third week of September, the reserves were $294 billion). It is uncertain exactly how many months of imports India can pay for – perhaps as low as eight – but it is definitely much less than what some would say is the ideal, 12 months.
The essential economic logic here is simple: when the current account deficit is so high, and well into the danger zone, how can the currency be allowed to appreciate unchecked? A rupee that increases in value will push up the domestic demand for oil and decrease the competitiveness of India’s exports — thereby worsening the current account deficit. There is clearly going to be no moderation in capital inflows, with New Delhi chasing FIIs so single-mindedly. So the RBI can clearly not sit on its hands forever. It will have to step in, sell rupees and buy dollars, thus building up reserves and keeping the rupee from appreciating too fast, and ensuring that it remains anchored to fundamentals — not too far, in other words, from the range prescribed by the RBI’s calculations of the real effective exchange rate, or REER. The government may not be completely happy. It has taken a short cut to fixing the fiscal deficit — hoping that a stronger rupee will reduce its oil bill, and that FIIs will drive up the stock market and make disinvestment more profitable. But the problems this creates for the current account deficit are obvious, and it’s the RBI that will have to fix them.