King Canute and the sea waves

Let the rupee find its own level but allow that to happen in a calibrated way

This is an apocryphal story. King Canute, the 11th-century Anglo-Scandinavian king, had his throne carried down to the seashore at tide. Sitting before the incoming ocean, he commanded the waves to recede so his royal robes did not get wet. The sea ignored him and washed over his feet.

 

Now imagine the Reserve Bank of India (RBI) as King Canute and the currency market as the sea.

 

Early last week, less than a week after the October monetary policy, RBI Governor Sanjay Malhotra told Moneycontrol that the central bank would do whatever it took to ensure orderly movement in the forex market.

 

On the same day, speaking at the Bloomberg New Economy Forum in New Delhi, Finance Minister Nirmala Sitharaman said the central bank's priority was to ensure orderly market conditions rather than defend a specific exchange rate. Her statement came days after the RBI unveiled yet another package of measures to calm the currency market.

 

In his post-monetary policy media interaction on October 7, Malhotra said: “By a number of estimates, including the REER, the rupee is not overvalued; it may be undervalued.” He also referred to the RBI’s dollar selling (in the context of how liquidity is being drained). REER is Real Effective Exchange Rate which measures the strength of a country's currency against a weighted basket of its major trading partners' currencies, adjusted for inflation.

 

What has the RBI done so far to ensure orderly market conditions or stop rupee depreciation? It depends on the prism we are looking through. But before that, here’s a quick recap of the history of rupee depreciation and RBI actions.

 

In 1997-98, during the East Asian financial crisis, the rupee depreciated roughly 10-12 per cent, sliding from 35.7 a dollar in mid-1997 to 39-40 by early 1998. India’s foreign exchange reserves were a modest $26-29 billion at that time.

 

The RBI tightened monetary policy by raising the rate and cash reserve ratio (CRR). Subsequently, it raised at least $4.23 billion through Resurgent India Bonds in August 1998 to shore up reserve buffers following the US post-Pokhran sanctions, and another $5.5 billion through India Millennium Deposits in October-November 2000 to counter capital flight during the global tech stock crash.

 

In 2008–2009, the rupee dropped 25-30 per cent, from 39-40 a dollar in early 2008 to 51-52 by early 2009 during the global financial crisis. Forex reserves dropped from a peak of $316 billion to $250 billion due to heavy market interventions and capital flight by foreign institutional investors (FIIs).

 

Besides aggressive dollar-selling in spot and forward markets, the RBI pursued an easy money policy, cutting the rate, CRR, and the Statutory Liquidity Ratio (SLR). The global financial crisis prompted monetary easing. The RBI also opened special forex swap facilities for oil marketing companies.

 

In 2013, during the taper tantrum, the rupee quickly depreciated by nearly 20-25 per cent, falling from 54 a dollar to a then-record low of near 68.8 in August while forex reserves dropped by $30 billion to $270 billion.

 

The RBI’s response was to open the Foreign Currency Non-Resident (Bank) – FCNR(B) – swap scheme (September-November 2013), attracting $34.3 billion in foreign currency deposits from non-resident Indians by subsidising swap costs. This time, too, it shifted the public sector oil companies' dollar demand directly to RBI reserves outside the open market and tightened liquidity. The central bank also hiked the rate of the Marginal Standing Facility – a window for overnight funds from the central bank in emergencies.

 

The rupee recovered from its low of 68.85 a dollar to around 62 within a few months – a 10 per cent appreciation – and foreign exchange reserves bounced back from $275 billion in mid-2013 to over $350 billion by early 2015.

 

In calendar year 2025, the rupee depreciated about 4.7 per cent, and in the current year, it hit an all-time low of 96.96 in May, representing a 7.3 per cent depreciation.

 

That prompted the RBI to announce a three-part dollar-rupee swap window for FNCR(B), external commercial borrowings (ECBs) and overseas foreign currency borrowings (OFCBs). They opened on June 8 and the FCNR(B) window closed on August 31, a month before the scheduled closure because of strong response. Overall, this scheme raised $143.6 billion, including $132.98 billion through the FCNR(B) channel.

 

Even that could not arrest the slide of the local currency. In the last week of June, forex reserves were close to $667 billion. Riding the FCNR(B) flow, it rose to $785.7 billion in the first week of September. Since then, it has dropped to $726.3 bn (on October 9), falling almost $60 billion in six weeks. 

 

Emulating the Chinese playbook, the RBI introduced a 20 per cent cash reserve requirement on any forex derivatives contract over $2 million. Called the Foreign Exchange Risk Reserve (FERR), this forces banks to set aside a certain portion of their total exposure and keep it with the RBI.

 

In stage two, the ambit of FERR has been extended to cover non-deliverable contracts involving the rupee for non-resident customers for the purpose of hedging.

 

At the same time, the limit for foreign exchange derivative transactions for users without needing to establish the existence of underlying exposure has been cut down from $100 million to $5 million. This is also applicable to exchange-traded currency derivatives, which involve the rupee.

 

Also, banks cannot allow any corporate client to rebook a foreign exchange derivative contract that was cancelled. This is meant for both deliverable and non-derivable markets. Of course, the rollover of foreign exchange derivatives contracts on maturity will continue.

 

Finally, the RBI has opened a window to meet the dollar demand of public sector oil companies.

 

The objective behind all these measures is to curb speculation in the foreign exchange market.

 

After touching almost 97 to the dollar on October 9, the rupee has bounced back to 94.96 on October 16. Will the trend continue? Is there anything else the RBI can do?

 

Indeed, we need stability in the currency market but there is a cost attached to it. Since the banks will have to keep 20 per cent FERR with the RBI, they will not be able to use that money for giving loans. So, the cost will be passed on to corporate India. It will cut down speculation, discourage importers to over-hedge but have an impact on corporate balance sheets.

 

What we have been seeing is that exporters are not selling dollars earned in a hurry (as they feel the local currency will depreciate further) and importers are going overboard on hedging (for the same reason), leading to a gap in supply. It’s the so-called lead and lag phenomenon in the market.

 

It’s not a foreign exchange market problem alone. We have a situation where the rupee is undervalued but Indian assets are not seen as attractive. We will have to attract foreign money flow. How? That’s the key question. Could be by tax incentives, asset prices finding the right level, higher domestic demand, policy rate hike…

 

At the moment, there is just one choice before us: Let the rupee find its own level and allow that to happen in a calibrated way. The villain of the piece is the price of oil. If it comes down, problems will be solved, even if temporarily. For now, let’s not choke everything – the companies need to breathe. 

 

Let’s end with a Chinese idiom: She ben qiu mo -- abandoning the root to chase the tip or branches. We need to address the root cause.  ____________________________________________________________________________________________________ 

The writer is an author and senior advisor to Jana Small Finance Bank Ltd. His latest book: Roller Coaster: An Affair with Banking. To read his previous columns, log on to www.bankerstrust.in. X: @TamalBandyo