Let the rupee be
Indian Express, 13 October 2008
The rupee has depreciated sharply in the last one month. In the coming days it is likely that the pressure on the rupee to depreciate remains high. Should the rupee be allowed to find its own level or should the RBI intervene to prevent rupee depreciation? Should the possiblity of importing inflation, when inflation is already a matter of concern, mean that the RBI should sell dollars to prevent the rupee from weakening further? I argue below that this would be a bad idea. The RBI should not sell its dollar reserves. The safest path is to let the rupee float, and to take steps to strengthen the currency futures market.
The rupee moved from Rs 44 at the end of August to beyond Rs 48 last week. Whether the RBI intervened to prevent rupee depreciation or not is not known yet since intervention data comes with a two month lag. Some media reports and foreign exchange reserves figures suggest that the RBI may have intervened to defend that rupee. If the RBI did intervene last week, then the policy needs to change now as the global crisis has worsened sharply last week.
There is a consensus amongst economists that a central bank must not come in the way of a fundamental adjustment of the exchange rate. However, many people think that it is better for a central bank to `reduce volatility'. Suppose the exchange rate had to move from Rs.45 per USD to Rs.49 per USD, and suppose RBI tried to spread this change of 10 paisa per day over a period of two months. In this period, the market would face a one way bet where the rupee is expected to depreciate.
When rational people see this one way bet, they would sell assets. First, it may be FIIs who are already selling rupee assets in order to return money to their investors. A temporary "good price" for the rupee would encourage them to sell while the rupee is still strong and before it weakens further. Next, it will be Indian residents, who would prefer to liquidate their investments in India and move rupees into dollars before the rupee weakens further. Containing rupee volatility in these times would set off asset sales in India by both foreigners and Indians, who would try to sell assets now in order to take money out the country at a favourable exchange rate. By trying to reduce volatility, RBI would trigger off a financial crisis.
Moreover, today the intervention in the rupee market may be through sale of dollars. Tomorrow, as the dollars start fast disappearing, the logical next step would an interest rate defence of the rupee. Once a central bank gets into a gamble like this, concerns about fighting speculators tend to take prominence, and the needs of the economy are not kept in mind. An interest rate hike would be like the action taken on 16th Jan 1998, when in the midst of the Asian crisis and a sharp business cycle downturn, the RBI tried to defend the rupee by raising interest rates by 200 basis points on a single day. With an impending slowdown this could do huge damage to the economy. Independence of monetary policy requires exchange rate flexibility. RBI should make monetary policy decisions while only thinking of domestic business cycle conditions, without a conflict of interest stemming from currency objectives.
The sale of dollars will also mean more rupees being sucked out of the system. Monetary policy will then have to scramble in sterilising this intervention, given how tight liquidity conditions already are. For the last 7 years we have seen how monetary policy got hijacked by the RBI's exchange rate policy. In this, it was a case of preventing appreciation. The RBI would buy dollars, then sterilise its intervention, then raise rates to prevent inflation, only to find that this futher attracted inflows. In the process it lurched from one mess to the other. Before we get into a similar though reverse kind of mess, the best policy is step away from rupee manipulation and to let it float.
One reason why RBI was able to continue to try to prevent rupee appreciation in recent years was the fact that there is no physical limit on how much of reserves it could go on piling. However, on the reverse side there is a limit and given the desperate global demand for dollars, this limit of zero reserves can be reached.
But what about inflation? Some observers argue that the RBI should intervene in the market to prevent the rupee from depreciating further as a weak rupee is inflationary. It is true that a strong rupee can reduce the pressure on prices. However, keeping the rupee strong for a few days, which is all that the intervention can achieve, is not going to do much to prices. Moreover, the impact of the exchange rate passthrough will be felt after a lag. During this time some part of it will be offset by lower global commodity prices owing to the declining demand in the world today. A decline in GDP growth is expected; this would put downward pressure on prices. Finally, in a time of global financial crisis, inflation concerns have to take the back seat. Financial stability and adequate liquidity should be RBI's prime concern.
What about the firms, who would be adversely affected by currency fluctuations? These firms need to be given well functioning currency derivatives market on which they can do their own hedging. Instead of the government trying to protect everyone from currency volatility, each firm should buy its own protection. The currency futures market at NSE has made a good beginning. SEBI and RBI had planned to reveiw the market to remove the restrictions that are holding this market back. This should be done right away so that businesses can buy their own protection when faced with high rupee volatility.
In summary, this is not a time for the RBI to try to prevent depreciation. Focus on the currency will be counter-productive. It should let the rupee find its own level, and encourage firms to protect themselves when faced with a volatile currency.
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