Rbi Prepared To Allow Rupee Appreciation In Short Term

The central bank steers clear of intervention band, but stays firm on curbing volatility

With the move towards capital account convertibility, the RBI has cautioned that it may be imperative for the central bank to allow short-term nominal appreciation of the rupee during periods of excess supply and to be prepared for aggressive intervention supported by equally aggressive sterilisation to defend the monetary objectives.

According to the market, while this does not indicate a targeted exchange rate, this definitely implies that the RBI will not allow the rupee to float freely and will intervene in the market to prevent any undue appreciation of the rupee.

While the RBI has recognised the need to adopt a real exchange rate rule, it has not referred to an intervention band in its annual report.

The RBI has warned that an open capital account would not only limit the authorities independence in the conduct of exchange rate policy but would also expose the economy to international shocks.

Following the introduction of a market-determined exchange rate system in 1993, there were large capital inflows which far exceeded the current account deficits and led to excess supply conditions in the foreign exchange market. This posed a fresh challenge for the monetary authority in the conduct of monetary and exchange rate policies.

With CAC on the cards, any strategy of targeting an exchange rate or the money stock adopted may be thrown off balance by unexpected flows. Substantial unexpected inflows will affect the nominal exchange rate. The other option, a freely floating exchange rate, may increase volatility and lead to persistent misalignments which could destabilise the financial system, eroding the credibility of an independent monetary policy.

As is stated in the RBIs annual report, To be consistent with the economic fundamentals, it may be imperative to allow short-term nominal appreciation during periods of excess supply, but the authorities would have to be prepared for aggressive intervention supported more often by equally aggressive sterilisation so as to defend the monetary objective.

Longer-term measures to prevent deterioration in external competitiveness such as increasing fiscal concessions, softer export credit, etc, should be weighed against the likely amount of losses on account of a higher debt service burden in th event of depreciation. The exchange rate regime, thus characterised, would involve an activism in the conduct of exchange rate policy.