How much should India prop up the rupee?

Source: The post is based on an article “How much should India prop up the rupee?” published in The Hindu on 30^th September 2022.

Syllabus: GS 3 – Indian Economy – Growth and development

Relevance: concerns associated with declining rupee and widening CAD.

News:  The rupee weakened against the dollar recording a low at Rs 81 per dollar in the last week. The Reserve Bank of India (RBI) has been intervening in the forex market to smoothen the decline.

Indian foreign exchange reserves have fallen to about $545 billion till mid-September 2022 in order to control the volatility.

How much of forex reserves should be used by the RBI to control the rupee volatility?

The use of forex reserves is appropriate at this point. Forex reserves are being spent to curb currency volatility.

It is not easy to fix the rupee at a particular level but it is possible to make it less volatile.

However, there is also a limit to rely on the reserves in order to control the rupee volatility.

How excessive intervention by the RBI can affect and forex reserves and what steps are needed?

Forex reserves can finish if RBI is aggressive in the intervention. Therefore, a holistic approach is needed. Thus, a multi-dimensional policy will be required, which includes easing provisions for remittances, allowing short-term foreign portfolio investments in government securities, etc.

Further a scheme to attract NRI investment can also be considered.

Depreciating the rupee sustainably will help the export sector and will address the challenge of high current account deficit (CAD) to some extent

Interest rate policy can be used to address domestic concerns and to help sustain the impact of the U.S. Federal Reserve’s rate hikes.

However, there is a limit to the RBI continuously managing volatility because its priority is price stability through inflation containment and not the exchange rate management.

What has been the reason for rupee volatility and what measures are required to address it?

The US Federal Reserve’s decision to increase rates is making foreign portfolio investors move out of emerging markets.

Geopolitical uncertainties like the war in Ukraine, energy price volatility has also contributed to this situation.

What is the level of forex reserves in India in terms of number of months of import cover and is this measure adequate?

The import cover is one way to measure reserves adequacy but it’s a very narrow one. There are other measures such as the Guidotti–Greenspan rule that looks at external debt that is less than one year.

Forex reserves should be sufficient to serve short term debt. From that point of view, we still have adequate reserves.

How can the real effective exchange rate (REER) be helpful for RBI in forex management?

It may not be a good approach and it is better to move with interest rate defense.

Therefore, addressing the macroeconomic fundamentals is necessary as it helped during the taper tantrum in 2013.

High inflation is also increasing the import costs which is widening the CAD.

However, we have already lived with CAD of 4% of GDP and it more important to come up with measures to finance the deficit.

Financing the CAD with capital inflows and preventing hot money outflow with the help of interest rates could be an effective long-term solution.

What are the consequences for the economy if CAD hits 4%?

Even during the tenure of Raghuram Rajan the CAD went up to 4% but as soon as hot money became volatile panic set in.

However, if RBI can operate the interest rate effectively that can check the outflow. But in using this tool RBI has to focus on the real interest rate and economic growth, i.e., R and G, for public debt management.

If the R is going to be greater than G then there is an unsustainable situation.

The only way to address these concerns such as fiscal consolidation, twin deficit crisis, a negative real rate of interest is to raise rates.

What are the concerns associated with the falling rupee?

As per an RBI report, 44% of the outstanding debt has not been protected and is vulnerable to forex volatility.

The rupee hasn’t seen the kind of weakness that it saw during the taper tantrum and now it is extremely orderly. The pace of rupee depreciation has not been very severe this time to cause concern. However, uncertainties remain.

Moreover, rupee depreciation and appreciation are market-based and it is based on demand and supply mechanism.

Therefore, RBI needs to intervene only if the rupee is on a sustained free fall.