Defending the rupee

Govt must act to contain BoP pressure

The Reserve Bank of India (RBI) late last week announced a range of measures to support the rupee. As a result, the currency appreciated against the dollar on Monday. The measures included restricting the rebooking of cancelled foreign-exchange derivative contracts involving the rupee for both deliverable and non-deliverable contracts. It also lowered the threshold for undertaking foreign-exchange transactions involving derivatives without establishing an underlying exposure to $5 million from $100 million across all dealers. Further, authorised dealers have to maintain cash with the RBI equivalent to 20 per cent of the rupee value for each foreign-exchange derivative contract involving the rupee with a notional value exceeding $2 million. Besides, the RBI decided to open a special window to address the foreign-exchange needs of the three public-sector oil-marketing companies (OMCs).

 

The expectation, of course, is that restricting trading in derivatives or increasing its cost will reduce speculation and take some stress off the rupee, which has been under pressure. However, these are at best stopgap measures and will not address the underlying problem. In fact, they could hurt genuine businesses that need to hedge foreign-exchange exposure. It has been reported that banks have made representations in this regard. Further, removing the OMC demand may reduce pressure in the foreign-exchange market, but it will not reduce their requirement for foreign currencies in any way. The relief in the currency market, therefore, is likely to be short-lived.

 

In fact, the RBI is intervening significantly in the currency market to support the rupee. The concessional swap arrangements, including for the Foreign-Currency Non-Resident (Bank) — or FCNR (B) — deposits helped accumulate foreign-exchange reserves, which increased to a record high of $785.7 billion in the week ended September 4. However, it has since declined by over $51 billion (October 2). Part of it could be on account of revaluation, but it does indicate that the central bank is fairly active in the currency market. The stated policy of the RBI is that it does not target any level and intervenes only to contain excess volatility. However, it seems to be looking at the other objectives as well.

 

It is worth highlighting that dealing with balance of payments (BoP) pressure is not the central bank’s responsibility alone. India is facing pressure on both the current and capital accounts, and the strain predates the war in West Asia. India faced BoP deficits over the past two years, partly because of capital outflows. This year will likely show a surplus because of strong inflows under FCNR (B). Again, FCNR (B) flows will give only short-term relief. The RBI’s recent action suggests that it is not helping even to the extent many had anticipated. Continued defence would only raise the incremental cost of pursuing this path. The textbook response to a situation like this is to allow the rupee to depreciate. However, it will help fundamentally correct the situation if Indian exporters are able to take advantage of a weak currency. For that to happen, the government needs to bring in reforms, including on tariffs. Further, the government needs to put in place conditions to attract foreign direct investment. It has been reported that the government is reviewing the framework for the bilateral investment treaty, but little is known in this regard. The present situation is a good opportunity to implement trade and investment reforms, which will provide much-needed stability on the external front and support higher growth over the medium to long term.