2 min read.Updated: 28 May 2013, 06:59 PM ISTRenu Kohli
The rupee’s volatility underlines the need for reserves to manage volatility—a policy tool the RBI no longer has
Last week’s global sell-off showed how volatile the removal of monetary accommodation could be. Triggered by fears that the US Federal Reserve will start withdrawing the punch bowl if the US economy improves, the tremors—with Japan as the epicentre—rattled India too. Stocks fell by 3% and the rupee shuddered—depreciating 0.3% on average daily, 1.4% over the previous week and hitting a low of ₹ 56 to the dollar. In May, the currency is nearly 4% down from its recovered February value of ₹ 54.
The rupee’s slide, in part from dollar strength, prompted finance minister P. Chidambaram and chief economic advisor Raghuram Rajan to temper investors’ interpretation of the Fed bombshell. The concern is understandable: the current account deficit is at about 5% of gross domestic product (GDP), with flighty portfolio capital financing the $100 billion gap; a weakening currency has no appeal for investors driven by global macro trades besides being inflationary and hurting public finances and private firms with dollar-denominated liabilities.
The jolt reinforces the inevitable turmoil and readjustments that will accompany the end of quantitative easing. India needs to be prepared for turbulence, especially as fuel supplies for global capital flows run out. Although Rajan ruled out any specific, panic-driven measures to support the currency last week, he favoured a stable rupee adding it was for the Reserve Bank of India (RBI) to take forex intervention decisions.
The question is whether the RBI has this artillery? Its capacity to intervene is crippled by its lack of foresight and neglect of the external position in recent times. It stopped reserves accumulation while managing the capital flow boom in 2009-10, preferring a hands-off exchange rate policy. And the existing reserve stock was depleted in coping with the sudden reversal of foreign capital in mid-2011 as the rupee fell headlong from ₹ 44 to ₹ 56 in a few months. Opportunities to recoup these losses dried up as capital inflow has barely fed the widening current account deficit, despite the buoyant revival from last September. The reserves’ cover for imports and short-term debt has fallen even as the current account became exposed to capital account shocks that are more frequent and abrupt, post-crisis.
The rupee has become highly volatile due to these developments, underlining the greater need for reserves to manage volatility—a policy tool the RBI no longer has. At $250 billion—$261 billion of foreign currency assets adjusted for $11 billion forward position—the current stock of reserves is stretched between competing claims of protecting external vulnerability and currency stabilization. These levels provide a very thin margin to RBI to prevent the rupee’s fall beyond ₹ 56. Last week’s events should have elicited a decisive intervention from the central bank as a signal to both sellers and investors, but its presence wasn’t reported. The trailer shows a wobblier road ahead, while the armoury stands depleted. The critical dependence upon foreign capital implies the rupee may need other support measures in the near future.
Renu Kohli is a New Delhi-based macroeconomist; she is currently Lead Economist, DEA-ICRIER G20 Research Programme and a former staff member of the International Monetary Fund and Reserve Bank of India.