Should RBI shift gear on its managed float of the Indian rupee?

The truly remarkable bit, however, is how gentle the slide has been, given the recent outflows from share sell-offs by foreign investors, strong dollar demand from importers and the greenback’s global gains in anticipation of Donald Trump’s policies.

Attribute this to how actively the Reserve Bank of India (RBI) has been managing the rupee’s ‘managed float.’

Since RBI intervention in the forex market has winners and losers both, a debate has arisen over it. A sharp drawdown of its forex reserves is a tell-tale sign of heavy dollar sales to support the rupee’s value. Left alone, it would have fallen more.

Critics of this tactic argue that the pursuit of short-term rupee stability has kept it overvalued, broadly, making our exports dearer overseas than stuff from rival countries that let their currencies slide freely.

Last week, Abhishek Anand, Josh Felman and Arvind Subramanian offered data to show that RBI has not just offloaded dollars, but also been using forward contracts to prop the rupee.

While this add-on device interferes less with monetary policy, most forex trading does. Indeed, multiple aims in the face of a macro trilemma make RBI’s job harder and more thankless. Should it not let the rupee float more freely to focus on its inflation mandate?

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The trilemma is this: An economy open to capital flows that pegs its currency to another does so at the cost of its tools for inflation control and growth propulsion going blunt.

This stems from an ‘impossible trinity.’ A country can sustain only two of these three: Openness to capital, a pegged exchange rate and an independent monetary policy.

The Gulf states that align their currencies with the dollar cannot determine how tight or loose local credit is. India opened its economy to foreign inflows in the 1990s, but kept a few outflow bars in place, never making the rupee fully convertible.

This partial setting spelt a dynamic trade-off between RBI’s handling of the rupee and the efficacy of its interest-rate policy. That India gets away with all three policies of the trinity kept in a grey zone—instead of a binary state of on-or-off—is a tribute to its trial-and-error ingenuity.

It isn’t easy to pull off this trapeze act. If RBI holds the rupee down against a dollar insurge by buying the latter, local inflation gets stoked by the liquidity injected, unless it’s mopped up via bond sales, which tightens credit. On the other hand, if it sells dollars amid outflows, it slurps up rupees.

To neutralize its drying effect, it must buy bonds (or lower cash reserve norms for banks, etc). Forward forex trades avoid this, but entail other risks.

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Whether RBI should let the rupee float more freely is a matter of strategy. Given an inelastic oil import burden, a fast-falling rupee can have a ripple-up effect on retail prices. An export boost led by rupee depreciation, which lowers the dollar prices of our stuff, could potentially outweigh that blow.

Yet, given the short-term risk of price instability, it would take brighter trade prospects, closer integration with global value chains and greater local value addition for a grand export bet to pay off.

An outward thrust would need import tariffs to drop too, and while we should launch one for the sake of faster economic growth, it’s for the government to lead this charge. Headway could then nudge Mint Street towards a market-priced rupee.

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