Floating on the rupee

Indian Express, 23 November 2011

The rupee has depreciated sharply in the last one week. We are fortunate that unlike countries in the Eurozone like Greece and Italy, who do not have the advantage of a flexible currency, we have one of the most important mechanisms of macroeconomic adjustment working our favour. However, the adjustment can happen only if accompanied by other supporting policy changes.

The recent fall of the rupee has been unexpected. Yet, as the dollar gets stronger against other currencies, this is not surprising. As the Eurozone crisis worsens, and as the Italian debt deepens, the dollar may see a further strengthening due to a flight to safety. Domestic Indian conditions particularly, the high inflation rate, the rising current account deficit and the weaking investment climate, have further added to the pressure on the rupee.

A major concern about the weaking of the rupee is that it will lead to an increase in prices of imported goods. However, if the fall of the rupee is to be restricted to a one time move in prices, rather than persistent inflation, India would need to have a central bank with a clear mandate of price stability that could peg inflationary expectations. Monetary policy would need to move away from conflicting objectives and be credible and consistent in its commitment to control prices. It would need to move away from rate hikes in an adhoc manner to a new framework work of accountability and communication. This could help prevent the depreciation from resulting in persistently high inflation.

If the exchange rate appreciates when the economy is booming and depreciates when it needs a boost in demand, it provides a stabilisation mechanism for the economy. Macroeconomic stabilisation policies like the fiscal and monetary policy are often constrained by political pressures, as in India and the Eurozone. If the currency of a country can move freely, it can provide one of the most important sources of adjustment for the economy. While countries in Southern Europe are trapped in the Euro, a currency that cannot adjust according to the needs of the economy, despite large current account deficits, India has the advantage of a currency that can help stabilize the current account deficit as well as boost demand for domestic products. By making imports more expensive and exports more competitive, a weaker rupee can help floundering demand.

The RBI has taken the correct policy stance to not intervene to support the rupee. The size of the foreign exchange market is so large today that it would require sizable intervention by the RBI to support the rupee. Once the market observes that this is happening, they would expect it to end when the RBI runs out of reserves, and as a consequence everyone would want to buy dollars immediately weaking the rupee further sharply. The RBI, therefore, cannot really prevent the rupee from depreciating. Morevover, even if the RBI could have prevented rupee depreciation, it would have been a bad policy option in the face of slowing GDP growth.

As depreciation makes imports more expensive, it reduces the attractiveness of importing and gives domestic production a boost by substituting domestic for foreign demand. At the same time, as Chinese exports lose competitiveness due to a strong currency, Indian exports gain competitiveness. When this is not happening by a policy of intervention in foreign exchange markets, but is market driven, it does not have the difficulties related to intervention and its sterilisation. A flexible exchange rate offers the Indian economy an automatic adjustment mechanism that is an imporant feature in the face of the expected slowdown in world trade and demand. Exports are still likely to get hit by the slowdown but to the extent that the currency can help improve demand, it will.

While many companies who have revenues in domestic rupees, but borrowing in dollars, will be hit by the weaking of the rupee, this is perhaps a good warning for the corporate sector. Those who failed to take a possible currency depreciation into account were actually speculating on currency movements by assuming that the rupee would either remain the same or strengthen. The policy of allowing higher currency flexibility by the RBI after 2008 has borne us well. Today, only a limited number of companies hold significant unhedged currency risk. However, it has been seen in the past that when the volatility of the currency is low through RBI intervention, companies start taking on currency risk. If a large number of companies have such risk on their balance sheets then it can create a problem of systemic risk in the economy. With international rates much lower than domestic rates, the attractiveness of borrowing abroad should always be considered in the context of the currency risk this involves. A sharp depreciation will bring this issue to the forefront in any borrowing decisions by companies.

A weaker rupee means that imports become more expensive. This should reduce the demand for imports. If however, domestic prices of imported goods, such as petroleum products do not move in line with a weaker rupee, their demand will remain high and the automatic adjustment that could have happened would not. At the same time, if the domestic price is not moving due to a subsidy by the government, it would mean a higher subsidy bill and larger fiscal deficits. With domestic inflation already high, there will be pressure on the government to increase the subsidy rather than to allow a pass through of the depreciation to higher prices. Not only would this worsen the already high fiscal deficit, it would mean that since imports would not adjust downwards, the current account deficit could rise. So unless domestic oil prices are allowed to rise in response to a weaker rupee, India could end up with a twin deficit problem of higher fiscal and current account deficits.

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