Do not defend the Rupee, RBI

Financial Express, 24 September 2011

Turmoil in global currency and stock markets has led to large movements in the rupee and it weakened sharply. Should the RBI have intervened in a big way to try to prevent rupee depreciation? Even under normal times, defending a currency is a difficult job. In present times, a central bank of one country trying to bravely fight the tsunami of financial flows with its little kitty of reserves would be a really bad idea. As the Rupee hit Rs 50 to a dollar, the best thing RBI could do was to keep away from the foreign exchange market.

If the RBI were to seriously intervene and to use its foreign exchange reserves to sell dollars in the market and steadfastly prevent rupee depreciation what would be the consequences? The RBI has USD 280 billion of reserves. This might seem to be a more than adequate level of reserves to defend any movements of the exchange rate. However, how long the amount will last, if used for propping up the rupee, would depend on how long the turmoil in global markets last. If people expect that the high level of uncertainty in the world economy would continue, it would be expected that at some point the reserves would either get exhaused or reach a level that the RBI would not be comfortable selling off more reserves. It would consequently be expected that the rupee would then depreciate. This is the typical story of a currency crisis. In such a situation all those who want to take rupees out of India, whether Indian or foreigner, whether banker or importer, would prefer to do it today rather than tomorrow. This could lead to a large outflow of money, exacerbating the pressure on the rupee and weaking it rapidly. A central bank trying to defend the currency under such speculative attack could quickly lose reserves and the currency could witness sharp depreciation. Many economies have seen this story play out.

A situation in which the central bank is expected to try to defend the currency also offers an opportunity for large speculators to attack the currency and make money by shorting it. The best known story of this nature is about the UK "Black Wednesday", the day the British pound had to leave the European Exchange Rate Mechanism (ERM). Under the ERM, Britain was required to keep the British pound within a permitted range of 2.25 percent of the German Deutche Mark to Pound rate of 2.95 DM to pound rate when it had joined the ERM. In September 1992 UK sharply raises interest rates, but the pound still weakened. George Soros shorted pounds expecting that UK will not be able to keep defending the sterling. He launched a speculative attack to speed up the depreciation of the pound, selling pounds, till the sterling hit the lower bound. The Treasury had no option but to intervene and defend the pound. Finally, on 16 September 1992, Black Wedenesday, the British government was forced to withdraw the pound sterling from the ERM. The UK Treasury is reported to have spent GBP 27 billion in trying to prop up the pound.

Asian currencies in the Asian crisis have similar stories. When a large depreciation happens in the context of a speculative attack, it is often sharper and larger than what happens in countries which do not try to defend their currencies and let them float. This is because the movement is then more determined by the turmoil in financial markets without an additional element of speculation being layered on. A large and sharp depreciation could result in a lot more businesses going bankrupt and the economy entering a recession. This is one of the main difficulties with fixed exchange rates, and why countries have moved to floating exchange rates.

What if no such speculative attack happens, and RBI is successfully able to prevent rupee depreciation? Is the right strategy then for RBI to defend the rupee? One might argue that the purpose of holding foreign exchange reserves is to defend the currency when the need arises, so that is what should be done now. One of the difficulties of a fixed exchange rate will be that it would encourage businesses to borrow in dollars. Already there is a large interest differential between India and international financial markets. Today some people might be discouraged to borrow at low interest rate in dollars if they expect the rupee to depreciation, because then they would have to return in rupee terms more than merely the interest rate at which they borrowed. This would reduce the attractiveness of dollar borrowing by Indian firms. If the RBI were to successfully defend the rupee, many more firms would find dollar borrowing more attractive. Indeed, firms and households, anyone who can have access to low cost foreign borrowing would borrow in dollars (even if they did not need the money themselves) and lend in rupees, keeping the margin as profit. Since few would expect the central bank to be able to defend its currency in the long term, this is likely to be short term borrowing. The consequence of a successful defence by the RBI is thus likely to be an increase in short term dollar denominated foreign debt. This would make the Indian economy even more vulnerable to a currency crisis.

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