The Indian rupee is once again struggling to hold ground. Clearly, all the noise that the government made in September on the issue of reforms and fiscal correction to revive investor confidence and talk up the Indian rupee is fading. As a consequence, after appreciating to 51/52 against the dollar in October, the Indian rupee is slowly slipping back close to the 56 mark.
As with any other market, the value of the currency depends on its supply and demand. Since the demand for foreign exchange has become relatively inelastic in India for a variety of reasons and does not respond adequately to the shift in global trade and capital flows, the urgency to increase foreign inflows to push up supply is only rising. This has not only added a significant amount of uncertainty on the external account, but has also resulted in relaxation of the rules on external borrowing, primarily to support the rupee. This increasing dependence on short-term flows has been on for a while now. Of late, it has accelerated.
At the macro level, the approach to addressing the issue of rupee volatility is fundamentally faulty. Policymakers, instead of tackling the reason for galloping demand for foreign exchange—imports—that has become inelastic, want to influence the supply side of foreign exchange, which is certainly not in their control. This can, potentially, have damaging consequences. Instead of worrying about pushing the rupee up at a time when the country is in the grip of an unsustainable current account deficit, the policymaking focus ought to be on unnecessary demand being created due to domestic pressures. Sure, it is important for India to attract global capital, but the quality and stability of foreign money is equally important. Further, higher-than-expected inflows from foreign portfolio investors, which have come in handy from a currency perspective, should not be taken for granted. Even as liquidity is expected to remain comfortable in the global financial markets, assumptions and preferences can always change. It is important that currency issues, which have their roots in shortcomings in domestic policy making, are addressed properly, rather than through short-term measures that can backfire.
What explains the volatility of the Indian rupee?