The new RBI should revert to old rupee policy to address challenges

The new Governor at Mint Road, Mumbai has arrived at a difficult moment. Economic growth has slipped, inflation remains elevated, while the international environment has become increasingly uncertain after a change of political regime in the United States. This is consequently not the time to bombard Sanjay Malhotra with unsolicited advice. Except on one critical issue, namely exchange  rate policy. 

  Our advice is simple: Abandon the strategy of the past few years and revert to the policy followed in the previous two decades.  

In our earlier piece in these pages, we highlighted the unwelcome consequences of the exchange rate policy adopted under the outgoing Reserve Bank of India (RBI) regime. We argued that the pursuit of an unnaturally stable dollar exchange rate has damaged India’s competitiveness by about 10 per cent (on average), while reducing reserves by about $100-$150 billion since October 2021. This piece makes two additional points, regarding the magnitude of intervention and its unwanted side effects, namely the tightening of monetary conditions at a time of slowing growth. Consider each. 

First, new data has come to light, showing that the intervention to support the rupee was far greater than we had estimated. We had used the change in reserves to proxy intervention. But it turns out that this approach underestimated the RBI’s activity by a considerable margin because the RBI was supplementing normal spot transactions with extensive operations in the forward market, which will only affect reserves months from now when the contracts are settled.   

Figure 1 shows that in the past three years forward intervention to support the rupee has been astonishingly extensive. In 2022, it amounted to $38 billion; in 2023, another $9 billion; and, based on reports from traders and in the press, in the first eleven months of this year, possibly a further $67 billion. It is striking that most of this intervention occurred frenetically since end-September in the lead-up to the decision on the Governorship of the RBI, as Figure 1 shows. In fact, over the past two years a substantial portion of   the net intervention to support the rupee seems to have been done in forward, not spot markets. Even more curious, much of this forward activity has taken place not in India but in the foreign “non-deliverable forward” (NDF) market — a market that in the past the RBI has been at pains to discourage.  

 

Why is the RBI utilising the forward market so heavily? For several reasons. Most obviously, because forward market intervention, especially in the unregulated NDF, is less transparent; it is consequently much easier for the RBI to hide its presence in the market. In addition, forward intervention allows the RBI to skirt the problematic side-effect of spot intervention, namely that selling dollars dries up domestic liquidity, as the banks’ rupees are used to purchase the foreign exchange. 

In contrast, forward transactions have no immediate effects on liquidity, since banks do not pay for their dollars until the contracts expire, typically in three months’ time. Even better, in the NDF market there is never any impact on domestic liquidity at all, since these transactions are settled entirely in dollars. No rupees are involved at all. 

Of course, there is a catch to the NDF. If the rupee depreciates more than expected, the RBI will need to pay out the difference in dollars, using its foreign exchange reserves. In other words, NDF positions amount to risky bets on the exchange rate, which carry the potential for large losses. Just to give a rough idea, if the RBI is short say $70 billion in the NDF market and the exchange rate depreciates by an unexpected 10 per cent, the central bank would incur nearly $7 billion in losses. This, in turn, would force the RBI to cut sharply the dividend it pays to the government. 

What’s more, despite the extensive recourse to the forward market, the RBI’s spot interventions have remained sizeable, leading to a substantial tightening of liquidity. In 2022, the RBI’s aggressive dollar sales in in the spot market drove liquidity below target, even creating a worrisome deficit, raising short-term rates in the process. As Figure 2 shows, something similar happened between October and December of this year. Liquidity again evaporated, pushing up market interest rates at a time when the economy was already beginning to lose momentum. 

To be fair, the RBI has recognized this problem, cutting Cash Reserve Ratio (CRR) by 50 basis points earlier this month, releasing Rs 1.2 trillion of liquidity into the banking system. But there is no getting away from the fact that the move came late, after several quarters of tight liquidity and as a consequence of intervention to prevent rupee depreciation. 

And of course, liquidity will soon tighten again if the RBI continues to sell dollars. 

In the end, the problem has arisen because the RBI has been pursuing too many targets: Low inflation, high growth, and exchange rate stability. This has put monetary policy into the classic bind of chasing too many objectives with too few instruments. Something had to be sacrificed, and that was the real economy — not just via a loss of international competitiveness but also via tighter monetary conditions, the combination of which has reduced exports 

and growth.  

A decade ago, the current government took a sweeping measure to address the excessive-target problem, passing the Inflation Targeting law to focus monetary policy on macro stability. Even with this simplification, the task of monetary policy remains exceedingly complex.  

So, our advice to the new Governor is this: Please don’t burden and complicate this already-difficult task by adding an exchange rate objective. It makes even less sense in the current circumstances. In fact, the best way to encourage growth right now is by allowing market pressure to depreciate the exchange rate and restore the nation’s lost competitiveness. Of course, if the pressures prove excessive and threaten financial stability, some response would be called for to limit the rupee’s slide. But apart from that extreme scenario, the new RBI should go back to the collective wisdom of all the RBI regimes prior to the most recent one. 

After all, there was much wisdom there.

  The authors are, respectively, with the Madras Institute for Development Studies, JH Consulting, and the Peterson Institute for International Economics