As the rupee has tumbled against the dollar, there is growing chatter about how the Reserve Bank of India should intervene to support the Indian currency. Its intervention in the foreign exchange market so far has been modest and ineffective as far as preventing a further fall in the rupee goes.
But defending a fixed exchange rate is easier said than done.
One of the key lessons policymakers have learnt over the past two decades is that countries should not target a particular exchange rate in a world where capital moves with freedom across borders. Countries that have tried to protect their exchange rate—be in Britain in 1992 or Thailand in 1997—have had to push up interest rates to levels that sent their economies spinning into recession. Thailand burnt up its foreign exchange reserves during its crisis.
Greece provides a more contemporary example of a troubled economy that cannot regain competitiveness through devaluation because it uses the common European currency. Defending a particular exchange rate will be akin to the central bank writing a put option; it will always be a losing trade in the long run.
The rupee is falling because of global risk aversion, but also because the trade gap is dangerously high. A cheaper rupee will help rebalance the economy, making Indian exports more competitive while making imports more expensive. The Indian rupee may not be undervalued in real terms right now, after taking inflation into account. So it is the rate at which the rupee has fallen that is the problem, rather than its direction.
The adjustment will not be easy, however. Many economic agents have taken decisions assuming a far stronger rupee. The recent devaluation will hurt them, especially the bravehearts who neither have natural hedges nor have bothered to buy insurance in the forward market. For example, one obvious point of stress will be in the balance sheets of companies that have piles of foreign debt, including convertible bonds. The dollar returns of foreign portfolio investors have also been sliced.
There is a nuclear option, to be sure. Malaysia tried capital controls in an attempt to manage both exchange rates and interest rates at the same time, and even the International Monetary Fund these days is prepared to accept that closing the capital account is acceptable in times of great stress. India is not in such dire straits right now.
Let the rupee find its own level. The policy authorities would be better occupied making India a more attractive investment destination in a faltering world economy.
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The rupee saga ( Full Coverage )