Modulated depreciation is salutary: S.S. TARAPORE

The RBI should sell dollars from its reserves only to smooth out sharp volatility in the rupee, but not fight a fundamental exchange rate adjustment.

May 17, 2012:  

The dollar-rupee exchange rate has been the centre of attention in the recent period. Top policymakers have been advocating defence of the present exchange rate and they are opposed to any further depreciation. The stemming of the rupee rate from further depreciation is implicitly based on the premise that the present exchange rate is viable and can be easily defended.

To assess the viability of the present dollar-rupee exchange rate, it is necessary to review the external payments position of India. The balance of payments current account deficit (CAD) in 2011-12 is estimated to be well over 4 per cent of GDP.

While we could, with bravado, dismiss the international rating agencies downgrading of India, there is no gainsaying that the lower rating would eventually reduce the confidence of investors, and unless we take strong remedial action, we could well see an unprecedented exodus of capital.

India's inflation rate has been, for quite some time, well above that in other emerging market economies (EMEs). The hope that our inflation rate will be on the downtrend is an article of faith. The overall political economy situation also does not generate confidence for foreign investors.

Fall in forex reserves

The foreign exchange reserves, which provided considerable comfort to investors, are now showing some signs of stress. With the volume of transactions rising rapidly, the forex reserves have fallen over the peak. The forex reserves are now equivalent to only 88 per cent of the external debt.

Furthermore, the short-term debt is 40 per cent of total external debt. A large part of the short-term debt comes up for refinancing in the period up to September 2012 and it is unlikely that refinancing will be possible at reasonable rates of interest.

In the recent period, the Reserve Bank of India has gone into overdrive to defend the rupee. These measures are reminiscent of the 1990s when administrative measures were taken to support the rupee. In the recent period, exporters have been required to repatriate 50 per cent of export earnings. Those holding Export Earners Foreign Currency (EEFC) accounts are expected to fully draw down their balances in these accounts before entering the forex market for purchases. Furthermore, controls have been imposed on forward market activity.

Top policymakers have explicitly pronounced that the forex reserves should be used to prevent any further depreciation.

Given the delicately balanced political economy situation, the authorities would not want critics pointing to the exchange rate management as being deficient. India Inc. has, all along, advocated a strong rupee or, in other words, cheaper imports. The adjustment then falls on the export sector. It bears stressing that export subsidy in terms of lower interest rates is an inefficient alternative to a reasonable exchange rate.

Exchange rate adjustment

Advocates of a strong rupee would claim that we have experienced a sustained increase in productivity while the rest of the world is lagging. Such ideas stir our macho spirits but are dangerous as they can lead to inappropriate exchange rate policies.

Now what can one make of the recent exchange management? In terms of the 6 currency real effective exchange rate (REER), the rupee appreciated by 19.5 per cent between September 2009 and July 2011, and then depreciated by 10.4 per cent between August 2011 and March 2012; the exchange rate depreciation in April and May 2012 probably implies that the appreciation up to July 2011 has been clawed back.

Ideally, the RBI's policy should be to aggressively buy when the rupee is appreciating excessively and sell when the rupee is depreciating excessively. Refraining from purchases on the upswing of the rupee but expending the reserves on the downswing would, over time, deplete the reserves.

Inflation rate differentials

If one wishes to move away from the REER, then the nominal dollar-rupee rate could be tracked over a longer period.

In March 1993, when the dual exchange rate was given up and a unitary market-determined rate was introduced, the rate stabilised for quite some time at $1= Rs 31.37.

Given that the secular inflation rate in India is at least 4 per cent per annum higher in India than in the US, the exchange rate should reflect relative inflation rate differentials and the exchange rate should now be around $1= Rs 66. Talk of a depreciation of the rupee to Rs 66 would be considered as blasphemy in official circles as also by India Inc.

If we want to avoid fundamental distortions in the economy, one of the prerequisites would be an appropriate exchange rate.

One recognises the danger of self-fulfilling prophecies, but the least the RBI should do in the immediate future would be to smooth out sharp volatility, but not fight a fundamental exchange rate adjustment.

To that extent, the RBI should intervene strongly by purchase in the forex market when the rupee appreciates, but undertake limited sales only to avoid excessive depreciation.

The problem is that political economy considerations would not allow the appropriate exchange rate adjustment to take place.

This could be unfortunate as monetary policy cannot bear the burden of fiscal imbalances as well as a fundamental disequilibrium in the exchange rate. In the absence of effective policy adjustment, India would face a sharp increase in inflation and a lower growth rate. 

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