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The exchange rate will soon have to play a bigger adjustment role
The rupee’s dollar value has only two of four determinants in its favour and will need more flexibility to ease other pressures
The currencies of most major economies have lost ground against the US dollar over the past year. The rupee is no exception. Only four of the 34 currencies tracked by The Economist every week have appreciated against the US dollar since October 2021—those issued by Russia, Brazil, Mexico and Peru. And if one leaves aside habitually mismanaged economies such as Turkey, Argentina and Pakistan, then it appears that emerging-market currencies have done no worse than their peers in the rich world, in stark contrast with the situation in 2013.
The extent a currency has depreciated against the US dollar in recent months is dependent on four factors: the structure of its trade, the state of its current account balance, the availability of foreign exchange reserves to intervene in the market as well as the readiness to do so, and the extent of borrowing in international rather than domestic currencies. Let us consider each of these factors, especially in the context of the Indian rupee.
First, a lot depends on whether a country or a currency area is a net exporter or importer of commodities. The former group has benefitted from rising energy prices while the latter has had to bear costs. India falls squarely in the second category. The price of its imports basket has risen more than the price of its exports basket, or a negative terms-of-trade shock.
Second, partly linked to the first point is the current account balance of a country. Countries with current account surpluses have less reason to worry about a sudden withdrawal of foreign capital from their shores. India has a wide current account deficit right now, as the domestic investment rate is higher than the domestic savings rate.
Third, most emerging-market economies have learnt the hard lessons of previous episodes of economic stress to build up a stock of precautionary savings in the form of foreign exchange reserves to deal with sudden balance-of-payment shocks. India is one such country. Rich economies have less reason to do so because they print global reserve currencies as well as have privileged access to the US printing press through swap agreements.
Fourth, countries in which most of the public debt is held by local investors have less reason to worry than countries in which the proportion of dollar debt is higher. On this front, India has been very conservative. The Indian government does not borrow abroad, and has provided foreign investors only limited access to its rupee debt. However, Indian companies do borrow abroad.
These are the four general principles. Two of them are in favour of India—a sizable stock of foreign exchange reserves and low levels of dollar debt. The other two are less favourable—a wide current account deficit and being a net commodity importer. The actions and future policy options of the Reserve Bank of India (RBI) in recent months can be viewed against this backdrop.
The Indian central bank has usually had an asymmetric response to pressure in the market for foreign exchange, as Ila Patnaik and Rajeswari Sengupta have shown in a recent paper that was presented in the 2021 edition of the India Policy Forum hosted by the National Council of Applied Economic Research. The two economists show that RBI has typically responded to appreciation pressure on the Indian rupee by purchasing foreign exchange reserves; and it has preferred to allow the rupee to slide when there is depreciation pressure, rather than use too much of its foreign exchange reserves to defend it.
It has been very much the same story since the pandemic struck. The foreign exchange reserves held by the Indian central bank soared from $480 billion just before the pandemic to $640 billion in September 2021. This was because capital inflows were far higher than what was needed to fund a shrinking current account deficit at the time. The situation has now reversed. The foreign exchange buffer is now around $110 billion lower than the September 2021 high, with $45 billion of dollar sales and $55 billion of valuation losses because of lower global bond prices.
India still has adequate foreign exchange reserves in terms of standard metrics such as import cover, foreign debt that is due within a year and the stock of broad money. However, the substantial fall in the foreign exchange hoard in effect means that the exchange rate will have to play a bigger role in economic adjustment.
Just two numbers are enough to illustrate the issue. First, foreign exchange reserves are now enough to cover only eight months of imports, going by the latest available monthly import bill. A six-months import cover is the bare minimum required. So, in effect, RBI now has a maximum of $120 billion to support the rupee. Second, India will also have a current account deficit of around $120 billion this financial year, which means the shortfall in capital inflows needed to fund the trade gap is that amount. The central bank will have to do a careful balancing act.
There is one more option: Using interest rates to defend the Indian rupee. However, a central bank with a formal inflation-targeting mandate should ideally use interest rates only to manage domestic demand and not the exchange rate. Using one policy instrument to target two policy goals is never a good idea.
Niranjan Rajadhyaksha is CEO and senior fellow at Artha India Research Advisors, and a member of the academic advisory board of the Meghnad Desai Academy of Economics.
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First Published:18 Oct 2022, 10:39 PM IST
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