Home / Opinion / RBI’s currency challenge

Divergence in monetary policy among the leading economies is playing out in the currency market. While the dollar, backed by better economic prospects and expectations of higher interest rates, is strengthening, the euro has been weakening on account of monetary easing by the European Central Bank. The Dollar Index, which reflects the strength of the dollar against leading currencies, has gained over 20% in the past one year. Meanwhile, the euro has fallen around 10% against the dollar since the start of 2015. The expectation is that a rate hike by the Federal Reserve will attract more capital to the US and can result in volatility in the financial market. In fact, Christine Lagarde, managing director, International Monetary Fund, in her recent address at the Reserve Bank of India (RBI), said that even if the process of normalization of monetary policy in the US is managed well, financial market volatility could result in potential stability risks. This is the reason why every single word in the Fed’s statement is being read by financial markets so carefully.

Interestingly, amid all this volatility and speculation in the global financial markets, the Indian rupee is showing significant strength. Despite the massive appreciation in the dollar, the rupee has depreciated just about 2% against it in the past one year. However, in the same period, the rupee has gained over 18%, 12% and 7% against the euro, the yen and the pound, respectively. While the risks associated with monetary tightening in the US has declined significantly compared with the second half of 2013, when India was in a near crisis situation, the problem at hand is now of excess inflows and overvaluation of rupee, which is hurting the real economy. The rupee has not only appreciated in nominal terms against several currencies, but has also strengthened in real terms. “One source of concern is muted export growth and rising non-oil, non-gold imports which could be affected by India’s deteriorating competitiveness, reflected in the appreciation of the real effective exchange rate by 8.5% since January 2014," noted the Economic Survey 2014-15.

RBI agrees that the rupee is overvalued, but continues to maintain that it will not intervene in the currency market to target a level. In his monetary policy statement on 4 March, Raghuram Rajan, governor, RBI, said, “The rupee has remained strong relative to peer countries. While an excessively strong rupee is undesirable, it too creates disinflationary impulses. It bears repeating here that the Reserve Bank does not target a level for the exchange rate, nor does it have an overall target for foreign exchange reserves."

However, thankfully, there has been a significant build-up in reserves after the shock of 2013. The foreign exchange reserve has gone up from the level of $276 billion in September 2013 to the current level of about $336 billion. Higher reserves will help RBI quell volatility if there is an outflow of capital as a consequence of higher interest rates in the US, especially at a time when debt flows have been rising. The total external debt for India has gone up from the level of $317.9 billion in 2010-11 to $455.9 billion in September 2014. Consequently, the coverage of foreign exchange reserve to total debt has declined from 95.9% to 68.9% during the same period.

Although RBI has created a buffer to deal with potential volatility arising from rate action in the US, it may not be willing to protect the competitiveness of the rupee, as is being advocated by many, for multiple reasons. For one, it is difficult to target a particular level in the currency market as the Swiss National Bank (SNB) discovered recently. In 2011, to protect the Swiss franc against rising capital flows, SNB decided to peg its currency against the euro with a promise to buy foreign exchange in unlimited quantities. It turned out to be a difficult promise to keep and SNB decided to break the peg in January 2015, resulting in a sharp appreciation of the Swiss franc.

RBI is unlikely to try the formula. Also, large intervention in the currency market will have implications on monetary policy. Simply put, when a central bank intervenes in the market to buy foreign currency, it increases the supply of domestic currency, which can lead to higher inflation. Now that RBI has become an inflation targeting central bank, it is likely to favour a stronger currency as it “creates disinflationary impulses". It may not want a situation where its intervention in the currency market compromises its position on the inflation front. So, though a rate hike in the US might lead to some volatility in financial markets in the short run, it might actually end up easing some pressure on the rupee.

However, even if the Fed raises interest rates, the move is unlikely to end the availability and flow of easy money in the near to medium term. Therefore, intervention may be required to protect the competitiveness of the Indian economy. There are two ways to do this. First, RBI intervenes in the currency market more aggressively without targeting a particular level, and by taking the government into confidence as the intervention may have fiscal costs at later stages. Second, the kind of foreign capital that India needs can be reassessed. An individual country may not be in a position to control the complex external monetary environment, but it can always decide the nature of capital it needs. A currency propped up by debt flows may not be in the best interest of the country.

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