There has been a rather muted reaction from the Reserve Bank of India (RBI) to the recent bout of rupee depreciation. Considering that this is the sharpest and steepest “adjustment" in the exchange rate—11% in two months—since the fabled “hop, skip and jump" in June 1991, it deserves greater attention and analysis.

Prima facie, the sharp depreciation is a market adjustment warranted by the fact that the nominal exchange rate hadn’t depreciated enough in line with the inflation differential. This made the rupee overvalued in real effective exchange rate (REER) terms.

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From April 2009 to July 2011, the six currency REER has increased from 96 to 119, which is about a 25% appreciation. Even on a wider basket of 36 currencies, which includes countries with higher inflation rates, REER has increased from 91 to 104, about 15%.

From an analytical perspective, the 11% depreciation in the rupee brings to fore the link between exchange rates and interest rates in the Indian macroeconomic dynamics. This aspect had gone on the back burner because of the rock-like stability of the exchange rate in the last six months or so despite an adverse environment. Also, with a mountain of foreign exchange reserves there is no need for any alarmist reaction.

However, given global fragility and the economy’s domestic vulnerability, the interplay of these interest rate changes and exchange rate movements will go a long way in determining developments in the nominal and real sides of the economy—inflation and real output—the two key variables that RBI is struggling to manage.

Two obvious implications of the rupee depreciation will be foreign institutional investment (FII) outflows and a knock on impact on inflation. The process of containing FII outflows will involve tighter credit conditions and an interest rate spike. As far as inflation is concerned, there is bound to be a knock-on impact of the weaker rupee especially if oil prices do not fall. With rupee-denominated oil inflation leading the Wholesale Price Index (WPI), it is axiomatic that a weaker rupee will boost rupee oil inflation, which in turn will push up the WPI.

Not only is imported inflation contributing almost one-third of the overall rate of inflation, incrementally the relationship is much stronger. For instance, in May 2008 when the rupee depreciated 5%, the WPI rose by 4% over the next three months.

Given the fact that RBI is fighting a losing battle against inflation, which it believes is commodity price-driven due to a spurt in global commodity prices, why did it allow the rupee to slide so sharply thereby jeopardizing its own anti-inflation strategy? This is a bit curious.

The last time around when the rupee came under pressure, RBI sold more than $40 billion to prevent the rupee from depreciating. In fact, in less than four months, RBI pushed $37 billion into the system to prevent the rupee from depreciating.

It hasn’t done so at this point of time as it has disruptive implications for liquidity management. By intervening and drawing down its reserves, it withdraws an equal amount of rupees out of the system causing an increase in the cash deficit. It would then require aggressive open market operations to restore the liquidity balance.

More importantly, the role of exchange rate goes much beyond the pass-through into domestic prices. In the present phase of the economy, exchange rate variability—in itself and vis-a-vis interest rate variability—needs to be understood for its contractionary implications.

Theoretically, the received wisdom is that exchange rates and interest rates exhibit a negative correlation as depreciations are expansionary. However, India’s import basket is not easily substitutable and has a robust demand, while its exports are easily substitutable and have less robust demand. As such, in an economy with a higher and inelastic import demand and a lower and elastic export demand, the overall effect of currency depreciation tends to be contractionary, even as it may have a positive effect on the current account deficit. The effect of the recent rupee depreciation is bound to be contractionary especially if global commodity prices do not reduce proportionately.

With a bourgeoning current account deficit, rupee weakening has become a part of the process by which credit is squeezed further. A drain in external funds almost always produces a credit squeeze and interest rate spike.

The interesting point is that RBI appears to have found the depreciation coming at a convenient time and hence has watched the rupee’s slide with interest and little else. It could well be using the slide as a substitute for another interest rate hike. If this indeed is so, the million dollar question on everyone’s mind about further monetary tightening may just have been answered. The only downside to this strategy is that the inflation-growth trade-off becomes much steeper.

Haseeb A. Drabu is an economist, and writes on monetary and macroeconomic matters from the perspective of policy and practice. Comments are welcome at