The rupee’s free fall is another headache for macroeconomic management in India. The newly established Financial Stability and Development Council (FSDC) proposes to discuss it at its next meeting, and economists are arguing for an objective look at the issue. There is scope for both.
The currency depreciated 4.3% and 6.3% month-on-month in August and September; on a year-on-year basis, it weakened around 9% in September alone. Compared to its Asian peers, the September depreciation was only lower than that of the Korean won, almost equal to the Singapore dollar and outpaced the fall in all other currencies. In August, the rupee’s fall surpassed all others in Asia. In terms of its own crisis-time history, the monthly slide in currency value tracks the 7% depreciation of October 2008, which followed a 3% dip in August 2008; it was followed by a further 5% fall in November 2008 (Chart).
Also See | Exchange rate movements (Graphic)
Is this, then, a repeat? And is there a case for changing tack?
The difference for policymakers to consider is the steady rise in exchange rate volatility since 2008. As the numbers on the accompanying chart show, exchange rate volatility in 2011 outpaces all of the post-crisis years. That is why 2011 is different.
This graphs India’s rising vulnerability to portfolio investment inflows, which are sensitive to the global risk-off environment. The trouble is that a reversal has second-order effects, notably upon confidence, which deters other long-term investment flows too. This matters enormously for a country with strong growth and expanding import demand – manifest in a persistent current account deficit – especially for oil. The elasticity of exchange rate and oil/commodity prices with respect to inflation is now such that rupee depreciation is offsetting the gains from softer oil and commodity prices. Looser monetary conditions are also pushing the central bank to rely more upon interest rates to achieve price stability. And private sector balance sheets are also at higher risk due to higher short-term debt (43% of total external debt by residual maturity at end-June 2011) and repayments on foreign-currency bonds.
Regardless of appreciation or depreciation, however, higher exchange rate volatility is a big disincentive for private investment that is often linked, directly or indirectly, to exports and imports. This needs to revive urgently to kick-off future growth. Looking back, and looking ahead, it is clear that reducing exchange rate volatility will contribute towards a more benign environment for growth. Western monetary policies and capital flows will be what they are. The important thing is to keep a steady ship in choppy waters.
Renu Kohli is Consultant Professor, ICRIER, and a former staff member of the International Monetary Fund and the Reserve Bank of India.