Central bank tries to get the rupee to swim against the tide

The Reserve Bank of India’s (RBI’s) latest round of policy salvos aimed at propping up the rupee is a bit like using a water pistol to put out a forest fire. The central bank declared that foreign exchange earners should convert 50% of their holdings in foreign currency accounts to rupee balances. Economists estimate that this will lead to an inflow of $2-3 billion (Rs10,660-15,990 crore today) over the next couple of weeks.

While that is a positive, it is a short-term measure and will have limited impact, considering that the average turnover in the foreign exchange market in India is around $40 billion. Even if one discounts the large non-deliverable forward market, forex transactions in the domestic market average around $10 billion a day.

Secondly, RBI has curbed the intraday open position limit for banks to five times the net overnight open limit. This is a follow-up move to measures it announced late last year to curb speculation, such as disallowing cancellation and rebooking of forward contracts and placing limits on hedging by traders. Ultimately, it will squeeze liquidity in the currency market.

While both these measures could provide some short-term support for the domestic currency, they don’t address the underlying problems responsible for the sharp depreciation of the rupee. That the current account deficit at nearly 4% of the gross domestic product is a problem is well known. But that doesn’t wholly account for the weak performance of the rupee. The Polish zloty and Turkish lira are some of the best performing emerging market currencies this year, despite these countries having much higher current account deficits.

The basic problem remains a waning appetite for the India story among foreign investors. To attract capital inflows, RBI also raised the interest rates on deposits from non-residents, the second time since November. But this might not prove to be very effective as well, going by the lessons from the first round. As the Hongkong and Shanghai Banking Corp. Ltd put it in a recent note, “Non-residents have already lowered their FX (foreign exchange) deposits from 30.8% of the total deposits (in November) to 26.7%.”

Direct intervention in the market is also a difficult proposition. The central bank sold a net $20 billion in the second half of the last fiscal year, a period when foreign reserves fell from $316 billion to around $295 billion. These measures also squeezed liquidity in the domestic market.

Moreover, inflation continues to be a problem perpetuated by the falling currency. For instance, in rupee terms, the Indian crude basket has fallen only 2.8% from the average of the last fortnight for April compared with a 5.1% drop in dollars. That gives the central bank less leeway to cut rates further, and thus the liquidity problem will continue to shackle its hands on intervening in the forex market.

In the end, these moves should be interpreted as a signalling mechanism—that RBI will allow the rupee to depreciate, but will take steps to moderate the pace of its decline.

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