Policy cues from a depreciating rupee

The exchange rate system has changed the world over. After the abandonment of the fixed exchange rate system adopted by the International Monetary Fund (IMF), there was a lot of confusion, leading to a series of conferences and consultations. Finally, developed countries moved to a market-determined exchange rate system; they care much less about rate fluctuations. Among them now prevails an attitude of ‘benign neglect’.

How has India managed the new regime since 1993?: On the whole, external sector management is a success story of the reform process. The current account deficit remained low at less than 2% of gross domestic product (GDP) from 1992-93 to 2008-09. There were two years in which there was a surplus. Between 2008-09 and 2012-13, it remained above 2% of GDP and in 2011-12 and 2012-13, it exceeded 4%. But financing the current account deficit posed no problem because of ample inflows on the capital account. The exception was 2012-13, when financing became a problem. Since then, the current account deficit has been modest, except for the current year when it can touch 3% of GDP.

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In the absence of capital flows, the exchange rate is largely determined by the current account of balance of payments (BoP). Exports earn foreign exchange and contribute to the supply of foreign exchange. Imports result in payment of foreign exchange and constitute demand for the same. But the picture changes with the inclusion of capital flows. Capital inflows add to the supply of foreign exchange and a strong inflow can lead to the domestic currency getting stronger despite a current account deficit. The purchasing power parity theory, which states that the external value of the currency is a reflection of its domestic value, holds good only when capital flows are minimal. Foreign investment (i.e. inflows) in India has been quite strong since 1994-95. In most years, it has been above 1.5% of GDP. In several years such as 2009-10 and 2014-15, it had exceeded 3% of GDP. These capital inflows, when they exceed the current account deficit, help RBI build reserves if it does not allow the rupee’s value to appreciate beyond a level. That is how our reserves have been built up to the present level exceeding $600 billion. This is far from how China built up reserves. China has primarily built its reserves out of its current account surplus. This makes a difference to the quality of reserves. Out of the various elements that have helped India accumulate reserves, some are volatile. The most significant among them is foreign portfolio investment. Investment in the stock market can flow out easily if perceptions change. Non-Resident Indian deposits are generally considered to be durable. But we found to our great horror how volatile they were in 1990 and 1991. Let us take two instances: the ‘taper tantrum’ of 2013 and the current situation after the Russia-Ukraine war. In the ‘taper tantrum’ period, there was a sudden withdrawal of funds through the sale of shares and that led to a steep fall in the value of the rupee. In May 2013, the value of the US dollar was equal to ₹55.01. By September 2013, it had risen to ₹63.75. But as sentiment got reversed and also as a result of certain actions taken, capital inflows resumed and the value of the dollar in terms of rupees fell. But it remained above its May level even after a year. Something similar may happen in the current situation. The value of the rupee, which has fallen steeply, may recover once capital inflows resume. But it may not necessarily touch the pre-crisis level.

What are the lessons from these experiences?: A shock to the value of the rupee can come whenever there are sudden withdrawals. Just as the inflow of funds helps to boost the rupee’s value, withdrawal of funds can lead to a fall in the value of the rupee. Volatile elements need to be kept under watch. When sentiment changes, these volatile elements give a shock. We need to accept this fact, and while taking action to reverse the sentiment, we must acknowledge the nature of the market.

We need, however, to focus on two related issues: one, the size of the current account deficit, and two, the behaviour of domestic prices. India’s problem until the end of the 1980s was how to finance the current account deficit. That may not be a problem now. But that does not offer us a licence not to mind the level of the current account deficit. Inflows in the nature of borrowings impose a burden of interest payments. As inflows increase to match or exceed the current account deficit, volatile elements in the reserves also increase, making for a shock from time to time. It is best to keep the current account deficit at around 1.5% of GDP, a level close to durable inflows. The days of a current account surplus at this point look distant. Second, despite large capital inflows, the rupee has depreciated. In June 1993, the value of the dollar was equal to ₹31.3. Today, it is equal to ₹80. Please remember that there was a time when it was equal to ₹4.75. It is here that purchasing power parity theory has some relevance. In the final analysis, inflation differentials between countries count. Export competitiveness is correlated with low inflation. Our own inflation targets cannot be too far away from the targets of other countries, if we want to contain depreciation of the rupee.

C. Rangarajan is former chairman, Prime Minister’s Economic Advisory Council, and former governor, Reserve Bank of India.

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