Foreign exchange reserves are only useful in reducing volatility and are not an antidote for poor economic management
The Indian rupee has depreciated more than 10% since the beginning of the year and is making headlines, especially after falling below the psychological mark of 70 against the dollar. Some experts have argued that India should raise foreign currency deposits from non-residents to support the rupee. As normally happens, the decline is also being used to attack the government. So, should one be worried about the depreciation in the rupee?
There are multiple reasons behind the weakening of the rupee. Interest rates in the US are rising, and the global financial system is adjusting to policy normalization. This has affected capital flows to emerging markets. Foreign portfolio investors sold Indian assets worth over $11 billion between April and June. The dollar index, which reflects the strength of the greenback, has gone up by over 5% since April. However, rising interest rates in the US are not the only reason for the depreciation of the rupee. India’s current account deficit (CAD) is also rising and is expected to go up to 2.5-3% of the gross domestic product (GDP) in the current financial year. Differently put, India is importing a lot more than it is exporting. Higher CAD in an environment of tightening financial conditions may continue to put pressure on the rupee.
Should the Reserve Bank of India (RBI) not intervene in the currency market to defend the rupee? RBI’s stated policy is that it only intervenes to reduce volatility and does not target any particular level. Moreover, a gradual depreciation will help the Indian economy at this stage. On one hand, a weaker rupee would contain imports, as their prices would go up. On the other hand, Indian goods will become cheaper in overseas markets, helping to boost exports. Defending the rupee by depleting foreign exchange reserves could further increase the CAD. Also, as economist Sajjid Z. Chinoy has shown in these pages, the fall in crude prices in 2014 resulted in a large positive terms-of-trade shock, which was largely spent and pushed up the real exchange rate. This affected India’s external competitiveness. Therefore, the ongoing adjustment is actually necessary to regain competitiveness. However, the depreciation will need to be carefully managed so that it does not affect market confidence. The pace of decline in the recent days has made markets somewhat anxious.
Although the fall in the rupee will help exports, there will still be some losers. Interest costs will go up for companies that have borrowed from abroad and do not have sufficient foreign currency earnings to service debt. However, businesses with external liabilities should be prepared for some currency fluctuations. It is sometimes argued that India should not allow the rupee to weaken, as it increases the price of imported goods and affects companies that have raised capital from abroad. This is a flawed argument. Not allowing the exchange rate to adjust on the downside will only increase the dependence on foreign debt and create further imbalances.
If the rupee depreciation is good for the economy, why was it a worry in 2013? The story is very different today than the taper tantrum episode of 2013. Though it can be argued that the fall in the rupee was triggered by external factors, India’s internal imbalances amplified the problem. Part of the reason was that India did not reverse its post-financial crisis fiscal and monetary stimulus in time, leading to higher inflation and widened CAD. Further, RBI did not intervene sufficiently in the currency market to absorb excess flows in the preceding period. The combination of these factors played a role in increasing India’s external sector vulnerability. However, the situation at the fundamental level is relatively better today. Inflation has come down, and India has adopted the flexible inflation targeting framework. The current account deficit was at a much lower level until recently, and the government is moving forward with fiscal consolidation. For instance, the Union government’s fiscal deficit in 2011-12 was close to 6% of GDP. In the current year, it is targeting 3.3% of GDP. The RBI also built foreign exchange reserves in recent years and is willing to use it to reduce volatility in the market.
How do we know that the RBI has adequate reserves? Assessing foreign exchange reserve adequacy is not easy because of the increasing global economic complexities. However, broadly speaking, reserves are said to be adequate if they cover three months of imports and short-term debt. India’s reserves fulfil these requirements. It is important to note, though, that reserves are only useful in reducing volatility and are not an antidote for poor economic management. If financial markets start believing that the country has problems at the fundamental level, then defending the currency can become extremely difficult. Therefore, it is important, particularly for an emerging market like India, to keep its house in order all the time. Although India’s fiscal position has improved in recent years, compared to peers, the combined deficit is still on the higher side. Also, analysts have started highlighting the risk to the current year’s target. The government should not allow the deficit to slip at this stage as it will increase macroeconomic stability risks.
Besides, it’s not always easy for RBI to intervene in the currency market as it has domestic liquidity implications. Intervention at times could be in conflict with its inflation targeting mandate. Therefore, avoiding significant overvaluation at times of higher inflows will be a challenge for the Indian central bank.