The rapid pace at which the rupee has lost value this week—a 2% fall on Monday followed by another 1% by Tuesday noon—has once again sparked off talk about intervention to stabilize the currency.
Reserve Bank of India (RBI) governor D. Subbarao explained on Monday that a failed defence of the exchange rate can be worse than no defence at all. Fair enough. But as the impending end to the US Federal Reserve’s quantitative easing hits the rupee, the Indian central bank’s past omissions—the failure to accumulate reserves because of a switch of a hands-off exchange rate policy and a lax monetary policy—return to haunt it once more.
RBI’s ability to make a credible and decisive intervention to manage exchange rate expectations—arrest panic investor selling, force exporters back into the currency market and prevent a negative feedback loop—requires sufficient backing of foreign exchange reserves, among other things. It is not clear it has this right now: excluding gold, special drawing rights and adjusting for $8 billion forward sales, reserves were $250 billion end-May; enough for 6.7 months of imports.
Short-term debt by residual maturity could be 40-45% of reserves (published estimate was 34% of reserves, end-March 2012). Investors watch these ratios, along with the net international investment position, to decide external vulnerability of a country.
Last week, RBI governor reaffirmed that the central bank does not target any exchange rate level but only intervenes to smoothen volatility. By any metric, exchange rate volatility—in levels as well as change—rose significantly last month and is extraordinarily high in June so far. How RBI defines volatility defies understanding. Tough action, even to smoothen exchange rate volatility, leave alone defending a particular level, is missing.
Repeated emphasis by Subbarao on the current account risks and its bearing on monetary policy has encouraged negative sentiment. Surely rapidly falling inflation, rising real interest rates and an improved fiscal position would suggest that risk, though elevated, is now in a setting of improved fundamentals relative to a year ago, something even the conservative rating agency, Standard and Poor’s recently acknowledged! Past experience shows that intervention combined with such talk is effective.
Policy responses for currency support have focused on tighter screws on gold imports and an expected rise in foreign debt investment caps. Curbing gold imports has never worked as past experience shows, while resorting to attract more portfolio debt inflows defies understanding. Foreign investors do not take exposure to long-term Indian interest rates and are, hence, bunched at the short-end (less than a year maturity), which exacerbates the swings in exchange rate and yield movements. Moreover, the bulk of portfolio capital inflow is in the equity market, whose resilience and buoyancy is the key reason why foreign investors are interested in India in the first place; bond yields matter far less to them.
A distinction between foreign short-term debt and equity flows is essential for macroeconomic response at this point. This must recognize the relative strengths of growth and interest differentials in attracting foreign capital, the race for which intensifies with the end of QE. Inflation risk from exchange rate depreciation is relatively little when judged against the weakness of aggregate demand. There is a role for monetary policy even as exchange rate policy can do little.
Renu Kohli is a New Delhi-based macroeconomist; she is currently lead economist, DEA-Icrier G-20 research programme and a former staff member of the International Monetary Fund and Reserve Bank of India.