The currency conundrum

A clear case for applying brakes on rupee appreciation

The "impossible trinity" - which postulates that an economy cannot have an independent monetary policy, an open capital account and a managed exchange rate at the same time - is a popular representation of the constrained choices that macroeconomic policymakers face. Reality, however, is far more complex than can be captured in simple trade-offs. Most emerging market economies - South Africa is a prominent exception - occupy a space somewhere between a completely managed exchange rate and a completely free one. India certainly falls into this category. It all depends on the context. Since 2007, the rupee has mostly been a floating currency, whose value has been determined by the difference between capital inflows and the current account deficit. But there have been occasions, particularly during episodes of high turbulence, such as in 2008 and 2011-13, when the Reserve Bank of India (RBI) used a combination of measures to prevent the rupee from free-falling. However, over the past several months, the weight of forces has shifted in the opposite direction. A sharp narrowing of the current account deficit combined with buoyant capital inflows are driving the rupee to appreciate, in a manner similar to the 2003-08 experience.

In this situation, the appropriate policy response is not as clear-cut. However, one legitimate line of reasoning is that when the economy is demand-constrained and monetary policy is changing its stance towards stimulating growth, an appreciating currency works against that objective. Resisting appreciation would actually reinforce the stimulatory impact of reducing interest rates. Viewed from another perspective, forex purchases by the RBI would inject liquidity into the banking system, creating that much more incentive to lend in what is clearly a very sluggish credit scenario. In other words, a pragmatic exchange rate policy would, as non-disruptively as possible, help to accelerate growth by not allowing appreciation to reduce export competitiveness. In the process, it would help the RBI increase its forex reserves; the global economic situation is far from being settled and more protection against shocks is a prudent objective. But will this stance actually help exports?

The indicator that is typically used to gauge this is the real effective exchange rate (REER), which measures the degree of overvaluation of a currency, drawing on the observed exchange rates and the relative inflation rates across a group of countries. The RBI monitors two REER indices - one with six countries, mainly the large developed economies, and the other with 36 countries, which includes many of India's global competitors. In December 2014, the rupee was about 10 per cent over-valued in the 36-country index, while it was about 20 per cent over-valued in the six-country index, relative to the base year 2004-05. Keeping in mind its inadequacies as a measure of competitiveness, these numbers suggest that export growth may be reined in by the present currency dynamic. Further appreciation, which is likely in a scenario of strong capital inflows, could hinder it further. In a situation in which the government has lofty aspirations of boosting domestic manufacturing, a strongly appreciating currency is one factor that goes completely against the grain. In the current macroeconomic situation, there are clear benefits to applying the brakes on the appreciation, to which the RBI needs to give due consideration.