A flexible approach: Orderly rupee depreciation should be allowed

Last Friday, the rupee fell to an all-time low of 85.81 against the dollar during intraday trading. Since then, it has clawed back a little, but is holding in the vicinity of 85.7 to 85.8. This gradual slide in the past few weeks is a good sign. Such depreciation was long overdue, and it is welcome that the Reserve Bank of India (RBI) is now willing to allow it to happen. The financial markets should not be allowed to think that the RBI is maintaining any sort of unofficial peg to a particular dollar value. The central bank has itself insisted that it does not do that but only smoothens out volatility in the exchange rate. However, the size of its intervention in both the spot and the forward markets for the rupee has given rise to many questions. Financial markets can respond to such questions by launching speculative attacks on a currency — which usually ends with some of the central-bank reserves being transferred to their bank accounts and the currency sliding anyway. Thus, the rupee’s very visible slide in recent weeks is an important signal in that it will induce speculators to look elsewhere.

 

The fact, however, is that the rupee weakened by less than 3 per cent last calendar year, which is considerably less than its peers. A small poll of market participants by this newspaper suggested that the general view was that the value of the rupee would decline further in coming months, driven in part by a further strengthening of the dollar due to slower monetary easing by the United States Federal Reserve. The rupee has a lot of catching up to do because its slide has been postponed when compared to its peer currencies and competitors. The effects on domestic liquidity of active management of the rupee are also beginning to be felt. A persistent liquidity deficit in the banking system caused short-term borrowing costs to rise this week to the highest they have been in more than three months, with some estimates putting the liquidity shortage at about Rs 1.1 trillion.

 

It is unclear what may have caused the RBI to revise its view on rupee management. Domestic-growth challenges must have played a part. An overvalued rupee is a drag on export and on growth. At a time when it has become clear that increasing the value of exports is the key to restoring growth momentum to the broader economy, maintaining an overvalued currency can be dangerously counter-productive. In fact, recent work by a team of RBI economists has shown that historically, in India, allowing depreciation in the real effective exchange rate (Reer) has had a significant effect on the trade balance. As former chief economic advisor Arvind Subramanian and others have pointed out on these pages, the rupee’s Reer since 2019 has stabilised at a much higher level.

 

Estimates suggest it is still overvalued by about 9 per cent. This must be brought back in line with real conditions if India is to regain competitiveness. Without liquidity in the banking system, with exporters fighting off an overvalued rupee, and with the threat of a speculative attack always hanging over the macro-economy, the task of reviving growth will become too difficult. A more flexible approach to the rupee’s value is overdue. This will be critical because the promised policies of US President-elect Donald Trump might strengthen the dollar further, at least in the foreseeable future.