For a central bank flagging the current account deficit as a larger threat than inflation, is the Reserve Bank of India (RBI) not taking excessive risk with its exchange rate policy? Galloping foreign capital inflows have led to a stronger rupee in recent times, reversing exchange rate expectations. But the external imbalance hasn’t got any better. Indeed, the RBI governor admitted on Monday that India is headed for the highest ever current account deficit this fiscal. Yet it prefers the currency to strengthen as its absence of buying some of the dollar deluge shows. To be sure, this helps contain imported inflation, besides taking some pressure off the fiscal deficit, targets close to the hearts of the central bank and the government. It also provides room for lower interest rates.
But currency appreciation also exacerbates the current account deficit problem, not to mention aggravated pressures should the flighty capital backing the rupee abruptly reverse. A sudden deterioration could put a spoke in this strategy of navigating through the inflation-twin deficit logjam by a combination of rising stock prices, capital inflows and an appreciating currency.
Since September last year, foreign portfolio capital inflow has revived as the US Federal Reserve unfolded its open-ended quantitative easing (QE3) and the domestic policy environment improved. Portfolio inflows aggregated $14 billion over September-December, surging to $8 billion so far this year. In response, the rupee moved up from Rs.55 in September to a range of Rs.53 this month. Meanwhile, a current account deficit extending beyond 5.4% of GDP in the last quarter of 2012 implies that the requirement of at least $12-14 billion of short-term capital inflow on a quarterly basis has increased some more.
With such diverse real and financial trends, exchange rate policy is exacerbating the disconnect. Data released on Monday showed RBI a net seller in November-December as it swapped to unwind its forward book a bit. There has been no sign of central bank intervention this year so far.
This also increases the likelihood of a sharper, eventual correction for there is little guarantee that such high levels of capital inflow will sustain. Though hard to predict their behaviour, past patterns show that capital inflow levels observed in the past 2-3 months in response to QE haven’t sustained beyond 3-4 months at a stretch before. This is because global portfolio rebalancing in response to readjusted US-foreign returns does not occur throughout the duration of QE. There’s uncertainty about their global levels too: this varied during QE1 (buoyant) and QE2 (dampened) because of disparate macroeconomic environments. Projections for 2013 on this are fraught with significant risks, according to IMF. Country-specific factors matter for this investor class. Here, the sentiment for India can be quite volatile: the very foreign investors, on whom the financing is critically dependent, care foremost about the current account deficit and external vulnerability indicators, including stock variables. On all these measures, India is seeing a rapid deterioration.
In these circumstances, the wisdom of a stronger currency—along with an interest rate cut last month—is hard to see. Building macroeconomic policy on the strength of volatile sentiments is a highly risky strategy. Changing tack to absorb some of the excess foreign capital inflow at this point will help restrain the deficit and boost foreign exchange reserves to secure against uncertainty ahead. This includes exchange rate support, should something go wrong globally or with the domestic situation. A policy that keeps the exchange rate closer to its fundamental value will serve current macroeconomic objectives far better.
Renu Kohli is a New Delhi-based macroeconomist; she is lead economist, DEA-Icrier G-20 research programme, and a former staff member of the International Monetary Fund and Reserve Bank of India.