The rupee’s sharp fall has elicited much discussion in recent times. Stemming from the country’s macro imbalances – an enlarged fiscal deficit and persistent high inflation spilling over into an unsustainable, big current account deficit – the currency’s weakness has been exacerbated by an external financing squeeze. Hence a much sharper fall relative to currencies of other emerging nations. This brings exchange rate management into focus. How do the policy makers perceive this?
There is little doubt that the measures the Reserve Bank of India (RBI) has taken to increase the inflow of foreign capital are remedial in nature and not really aimed at fighting a fundamental exchange rate adjustment. The central bank is more managing the pace of currency depreciation than supporting the rupee at this or that level. With foreign exchange reserves down to six months of import cover, short-term debt above 40 per cent of overall external debt and significant foreign currency liabilities due for repayment in the near term, the RBI knows better than anyone that it can only do so much and no more. The RBI also must be conscious of the fact that it did not buy any foreign currency to accrete reserves when the rupee was on the upswing since 2009. But it is now forced to sell to moderate the depreciation, which is unsustainable beyond a point as it will only deplete reserves.
The government, on the other hand, is still pinning the blame upon global developments, dismissive of the downgrade of its sovereign rating outlook and perhaps still not mindful enough of tiring investor confidence, a reversal of which could trigger a more serious capital outflow. Early signs of this are apparent in rising repatriation of foreign direct investments from India, although the reasons for this are yet unclear, according to Nomura’s Sonal Varma.
There is still a lingering expectation that the exchange rate can be viably defended with the current level of reserves. Indeed, the distress over a currency weakened by daily hammering contrasts notably with the swagger about a strong rupee a year ago when short-term capital inflows were good but the macroeconomic fundamentals were not so much better.
A more sobering realisation would be that the currency has merely retreated to its fundamental level as the illusive cover of volatile foreign capital inflows has blown off. In the two years to April 2011, the exchange rate appreciated more than 18 per cent in real effective terms (six-currency) even as the fiscal and current account deficits remained above five and 2.5 per cent of GDP respectively and inflation averaged an annual 10 per cent. At current levels, the rupee has just about shaken off that high. Indeed, given that the current account deficit has expanded at least 1.4 percentage points since, there still might be some more depths left for the currency to plumb.
The current experience is instructive for exchange rate management. The point here is the inherent asymmetry in fighting an appreciation or depreciation. In the former, the central bank is buying another country’s currency with the domestic currency; so in theory at least, this could be infinite, for it is expending its own currency, although there are costs attached to the exercise. However, in fighting depreciation – especially in which the exchange rate is undergoing a fundamental adjustment to an equilibrium value – a foreign currency is being sold for which there is no boundless resource.
Some realisation that a more correct approach would be to remedy the macro imbalances instead is dawning, as reflected in the 11.5 per cent increase in petrol prices recently. It would be both practical and sensible to back this up with some adjustment of diesel prices in the near future. This will add to inflation no doubt, but will nevertheless induce some fiscal correction by containing the subsidy bill; importantly, it will temper oil demand and contain the import bill. Add to this the ongoing correction in gold demand, which is moderating due to higher taxes and import prices. All this should assist the RBI in its monetary policy, currently reeling under the burden of fiscal overstretch. It will also take the pressure off the central bank to prop an unsustainable exchange rate.
There are sobering lessons here for exchange rate policy too. A currency appreciation driven by volatile capital flows and accompanied by persistent, large current account deficits is both dangerous and eventually unsustainable. Cheaper imports are undoubtedly attractive, but without an offsetting adjustment from the exporting sector, such an exchange rate regime only exposes the current account to higher volatility via frequent financial shocks from abroad. It is important to recognise that an appropriate exchange rate is as essential to avoid fundamental distortions as are fiscal and current account deficits.
The writer is a New Delhi-based macroeconomist; she is a former staff member of the International Monetary Fund and the Reserve Bank of India