Since January 2008, the rupee has seen three big trending moves. First, it dropped from Rs 39.27 per US dollar in January 2008 to Rs 52.06 in March 2009. Then it strengthened, peaking at Rs 44.03 in November 2010. Now it has slid again, to an all-time low of Rs 52.70. The gyrations have been strikingly correlated to hot flows. Portfolio investments from abroad peaked in January 2008, as did the stock market. Portfolio investment outflows started in late January 2008 and foreign institutional investors (FIIs) were net sellers until March 2009, when the rupee (and the stock market) bottomed. The next phase of rupee strengthening coincided with India once again becoming an attractive FII destination. The stock market hit its last peak in November 2010, which coincided with the rupee’s peak. Since then, FIIs have been net sellers. The recent rupee low and the recent equity index lows coincided, once again.
The rupee is not a free-float currency. There are capital account controls, though these have admittedly been relaxed significantly. Hence, the Reserve Bank of India (RBI) could intervene forcefully at any point, if it so desired. The evidence suggests, though, that the central bank has been a bystander, making only token interventions. This means a shelving of the earlier “dirty float” philosophy of targeting a band (plus/minus five per cent) of the so-called Real Effective Exchange Rate (REER), which adjusts for differences in inflation between India and a handful of major economies. The new approach has macroeconomic implications. The most obvious impact of the rupee movement is on trade. On the one hand, a weaker rupee makes exports competitive. It may, in fact, be necessary to maintain parity in competitiveness, given a policy of deliberate under-valuation by China. On the other hand, a weaker rupee increases import costs, and thus fuels domestic inflation. Over 70 per cent of the import bill is inelastic, consisting of energy commodities like crude, liquefied natural gas and high-quality coal.
India’s external debt stood at $305 billion on March 31, 2011, and it has increased since. Foreign exchange reserves net of debt would be either negative or close to zero. The commercial component of external debt was around 28 per cent in March 2011. RBI statistics show that borrowing through various windows has risen at an average of $2.5-3.5 billion per month in the current fiscal. This is not surprising, given a hike in the limit for external commercial borrowing under the automatic route and widening differentials between domestic and hard-currency interest rates. Currency depreciation also makes it more expensive for companies with rupee earnings and forex-denominated debt to service obligations. Many companies have also written off losses on the forex account in the past couple of quarters, due to misconceived or inadequate hedging action.
A third variable worth considering is import substitution. In theory, a weak rupee allows higher protection for domestic industry. In practice, currency volatility makes it a big gamble for domestic manufacturer to build capacities, which may become unviable on another rupee rise. Should the RBI use the policy tools it commands, and revert to the dirty float by targeting a more predictable band around REER once again? As things stand, the advantages could outweigh the disadvantages. Given the current global turmoil, nobody can guarantee currency stability and, indeed, that shouldn’t be attempted if it involves depletion of reserves. But a base level of exchange rate predictability would help both companies and policy planners to plan for the future with greater confidence.