Reserve Bank moves to eliminate sharp currency volatility

While most foreign investors would like to see volatility in the rupee to be fixed, the Reserve Bank of India (RBI) says its frameworks on inflation and liquidity are aimed at ensuring such volatility is ironed out.

So far, RBI has intervened directly to deal with currency volatility. Even as the central bank would continue to do so, the process would become much more predictable and automatic under the frameworks cited above.

Investors are concerned about volatility because they stand to lose if the currency depreciates more than the actual returns in the investment period. Will RBI's new frameworks result in no fluctuation at all for the rupee? No, say currency dealers. It would still respond to global and domestic cues. But, the exchange rate would self-adjust to its right level (depending on inflation differential) over a short period.

The key to neutralising rupee volatility lies in the inflation targeting mandate of the new monetary policy framework that guides RBI. The central bank wants to bring down inflation to a predictable path to eventually settle at around four per cent. The new liquidity framework would ensure liquidity remains comfortable at all times, negating the chances of short-term rates to harden. Both frameworks would ensure the exchange rate would become a lot more stable.

Recently, RBI Governor Raghuram Rajan had said efforts were on so that investors worry less about exchange rate.

"Our aim in the macro stabilisation is to make the exchange rate less and less an issue that investors have to worry about," said Rajan. Adding, "If we move towards our inflation target of around four per cent, then the past years where you had extreme volatility in the rupee because rupee inflation in India was much higher than the world, will become a thing of the past." By these words, Rajan meant this: In an economy that receives funds from outside, theoretically, the exchange rate is determined by the inflation differentiation between the source country from where funds are coming and the recipient country. The more the inflation in the recipient country, the higher the depreciation of the local currency should be and vice-versa. If the inflation level of the recipient country fluctuates, so does the exchange rate; thus, a predictable inflation level would mean a predictable depreciation level in the local currency. Any predictability would mean a sharp reduction in currency volatility.

If inflation is predicted to be firmly anchored around a level, the guesswork in the market goes, say economists. If inflation overshoots the target, RBI will not hesitate to raise rates. The predictability in the market, then, aids in a stable environment attracting inflows, they say.