Why the RBI should let the rupee fall

The Reserve Bank of India (RBI) has been trying to hold the dollar under ₹80 for a while now. So, what led the RBI to let go finally?

First, the US Federal Reserve increased the federal funds rate, its key short-term interest rate, by 75 basis points to 3-3.25%. It also made it clear that it will continue to raise rates through this year. This means that a lot of money from all across the world will keep going to the US, making the dollar stronger and other currencies weaker.

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Second, RBI has been defending the rupee by selling dollars from its reserves and buying rupees. This worked because a lot of money was floating around in the system, which banks had no use for. Until recently, when the RBI sold dollars, it was this excess liquidity of rupees that it was sucking out. This excess liquidity ended on 20 September.

From now on, any defence of the rupee will lead to a shortage of rupees in the financial system and drive up interest rates faster than RBI might perhaps be happy with.

Also, as the RBI has defended the rupee, India’s trade deficit has burgeoned. The trade deficit is the difference between exports of goods and imports. The trade deficit from April to August stood at $123 billion against $53.9 billion during the same period last year.

A major reason for this is that India imports a bulk of the oil it consumes. This year the import dependency has been 86.5%. From April to August, the price of the Indian basket of crude oil has averaged (simple average) $106.3 a barrel compared to $69.1 a barrel in the same period last year. The upshot, the oil bill has soared to $99.4 billion against $52.8 billion last year.

Further, it’s not just the oil imports that have increased. Even the non-oil non-gold non-silver imports are up this year. They were $200.2 billion from April to August against $146.6 billion last year.

The overall goods imports this year have gone up by 46.2% to $319.3 billion. In comparison, the goods exports have risen by just 19.4% to $196.3 billion, leading to the trade deficit shooting up. One reason for this has been the high price of oil. However, there is another reason as well.

Between the end of 2021 and now, because of the continuous intervention by the RBI, the rupee has depreciated by around 8.9% against the dollar, which is lower than many other such currencies. This essentially implies that the rupee is overvalued, making exports uncompetitive to some extent and non-oil imports cheaper than they otherwise would have been. Hence, it’s important to let the rupee depreciate, leading to higher prices of imports in rupee terms. Higher costs of imports should help drive down non-oil imports and control the trade deficit.

A weak rupee will feed into a higher oil price in rupee terms. Nonetheless, oil prices have been falling for a while and are down to $90.75 per barrel against a high of $128.2 per barrel in early March.

Further, RBI has been exhausting its dollar reserves at a very fast pace. Its foreign currency assets are down to $484.9 billion as of 16 September from $569.4 billion in early January. This is at a time the supply of dollars through IT exports and remittances, which help narrow the trade deficit gap, are expected to take a hit this year because of the increased chances of a recession in the rich world.

Against this backdrop, it makes a lot of sense for RBI to overcome its obsession with defending the rupee at any cost.

Elsewhere in Mint

In Opinion, Manu Joseph writes about the power of the second rung of the elite. Nitin Pai argues why liberals have strong reasons to be conservative. Amit Kapoor & Bibek Debroy write why India’s success matters to the world. Long Story explains how the world grapples with the US Fed rate hikes.