A sensible intervention

But the long-term impact of reserve building should be assessed

Recent reports suggest that the Reserve Bank of India (RBI) is now steadily intervening in the foreign exchange market, buying up dollars to enhance its reserves. A collateral consequence of this is that it prevents the rupee from appreciating in response to what has been a significant capital inflow over the past several weeks. As it happens, both objectives have been advocated by several commentators. The first objective, that of enhancing reserves, is justified by the assessment that the recent surge in capital inflows has essentially been motivated by strong expectations of a new government coming to grips with the economy's structural problems. If, for any reason, these expectations are belied, the surge could very well reverse direction, resulting in rapid rupee depreciation, which destabilises the economy on a variety of fronts. Even if the movement itself cannot be reversed, greater capacity to smooth and contain it by using reserves to intervene will contribute to quicker stabilisation.

The second objective, that of preventing rupee appreciation, is motivated by the need to reinforce the gain in competitiveness of Indian producers as a result of the recent depreciation. Over the past few months, both exports and imports have responded as expected to a lower rupee, contributing to the very sharp narrowing in the current account deficit. At this juncture, rupee appreciation would threaten this positive development, particularly when relatively high inflation is already eroding competitiveness by contributing to an appreciation in the real effective exchange rate. Persistent rupee appreciation could lead to a return of vulnerability on the current account front.

However, there's no such thing as a free lunch. Intervention is, intrinsically, inflationary; it works through two major channels. First, by purchasing dollars, the RBI injects more rupees into the domestic financial system, thereby boosting liquidity, which can provoke inflationary pressures. Second, by making exports more attractive and imports less so, it stimulates demand for domestic products. The latter channel, at least, does not pose much of a threat in a situation of sluggish growth, idle capacity and low inflation. But, clearly, the Indian economy, while satisfying the first two criteria, is somewhat fragile on the third. Given that the RBI has apparently hardened its commitment to controlling inflation, it should hardly be expected to throw caution to the wind and risk aggravating the situation again. If it does, in fact, put a premium on strengthening its defences against external shocks, it will have to find ways to offset the stimulatory impact of intervention.

It does have the means. It can "sterilise" the potential increase in domestic liquidity by selling government securities to banks. This has been done before, between 2004 and 2006. It helps, but it isn't perfect. It can also offset the increase in demand by raising interest rates to contract domestic consumption and investment. This will clearly not go down well with the business community, which is going to use whatever leverage it may have with the new government to try and prevent it. In short, the RBI will have to maintain a difficult balance between conflicting forces. Even as a larger reserve may be a sensible objective in the short term, the longer-term consequences need to be carefully assessed.