New Delhi: India needs to allow its rupee to be driven by market forces to minimize external risks and should intervene only to address “disorderly market concerns", the International Monetary Fund (IMF) said on Tuesday.

“Exchange rate flexibility should remain the main shock absorber, with intervention limited to addressing disorderly market concerns," it said in its latest external sector report.

Outgoing chief economic adviser in the finance ministry Arvind Subramanian in an interview to Mint earlier this month supported the view to allow the rupee to depreciate.

“If oil prices rise and other currencies depreciate, the rupee depreciating has to be part of the adjusting mechanism. To say that the rupee should not depreciate when all these shocks are happening is just bad economics," he added.

The average real effective exchange rate (REER) for rupee in 2017 appreciated by about 4.1% over its 2016 average. As of May 2018, the REER depreciated 3.6% relative to its 2017 average.

REER is the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several foreign currencies) divided by an index of costs. An increase in REER means exports become more expensive and imports become cheaper; indicating lower trade competitiveness.

“Based on the CA (current account) gap, the REER is assessed to be in line with fundamentals with the range of -7 to +5 percent for FY2017/18," IMF said.

IMF said the external sector position of India in 2017-18 is broadly consistent with fundamentals and desirable policy settings. “India’s low per capita income, favourable growth prospects, demographic trends, and development needs justify running CA deficits," it added.

The multilateral lending agency said while external vulnerabilities for Indian economy remain, they have been reduced since 2013. “India’s economic risks stem from more volatile global financial conditions, oil price volatility, and a retreat from cross-border integration. Progress has been made on FDI (foreign direct investment) liberalization, while portfolio flows remain controlled. India’s trade barriers remain significant," it added.

Suggesting potential policy response, IMF said an increase in non-debt creating capital flows through FDI will help improve the current account deficit financing mix and contain external vulnerabilities.

“Gradual liberalization of the portfolio flows should be considered, while monitoring risks of portfolio flows’ reversals. Continued vigilance is needed, given potential external shocks. Going forward, further structural reform efforts to revamp the business climate, ease domestic supply bottlenecks, and facilitate trade and investment liberalisation are essential to improve competitiveness and investment prospects, attract FDI, and boost exports," it added.

India’s current account deficit increased to about 1.9% of GDP in 2017-18 from 0.7% of GDP in the previous year, reflecting a recovery in commodity (especially oil) prices. “Over the medium term, the CA deficit is expected to increase to about 2½% of GDP, on the back of strengthening domestic demand," IMF said.