Rupee depreciation is a managed fall

If there is no currency crisis, the media may invent one. It’s in the nature of 24×7 news coverage that every fall in the rupee in recent weeks should lead to questions as to whether we were facing a repeat of 2013 or worse. The Reserve Bank of India’s (RBI) silence on the subject should have been eloquent enough: What is happening is a managed fall in the rupee consistent with our fundamentals and developments in the global economy. 

The current account deficit increased modestly from $15 billion in April–June 2017 to $15.8 billion in the period April-June 2018. Capital flows to finance the deficit dropped sharply from $27 billion to $5 billion in the same period. It’s not just that we are running a deficit on the current account. We aren’t getting enough capital to finance it. Even under normal circumstances, an annual depreciation of 4-5 per cent would be in order. In the present situation, a depreciation of a higher magnitude is only to be expected. 

As analysts have pointed out, judging the rupee in relation to the dollar alone is misleading. The dollar has appreciated against all currencies. Data from the Federal Reserve Bank of St Louis shows that a trade-weighted measure of the dollar has appreciated from 84.7 on February 1 to 90.6 on September 10. Most analysts ascribe this to the rate hikes in the US and changes in tax laws that incentivise American corporations to bring more of their overseas profits into the US.  

We get a better picture of the rupee’s value from the real effective exchange rate (REER). The 6-currency REER based on the consumer price index  (CPI) was 100 in January 2017. Thereafter, it appreciated to 105 in August 2017, a real appreciation of 5 per cent. It has since depreciated to 98 in August 2018, a depreciation over the year of 6.6 per cent in a year. This is just a little beyond the informal band of 5 per cent for REER that the RBI used to have for containing rupee volatility. 

Effectively, the rupee has depreciated 2 per cent in real terms against a basket of six currencies since January 2017. That is pretty modest in relation to changes in the external account.  Small wonder that the RBI has not moved beyond limited intervention in the currency market thus far.

The big question for the markets is whether and when the RBI will resort to a rate hike in order to prop up the rupee. The short answer is that we do not, at the moment, have a situation on our hands that requires the RBI to use the interest rate to deal with rupee depreciation. 

In the inflation targeting framework we now have, the focus of interest rate policy is on inflation. CPI inflation came in at 3.7 per cent in August. Most analysts believe that inflation is likely to stay below 5 per cent this year. For the RBI to use the interest rate in relation to the exchange rate would probably require some trigger from the outside — maybe, a worsening of the trade war between the US and China or a geopolitical crisis related to full US sanctions on Iran kicking in in November or signs of further investor aversion to emerging markets.

The government has announced measures aimed at addressing the current account deficit and capital flows. Withholding tax on rupee-denominated bonds has been scrapped. Manufacturing companies can avail of external commercial borrowings up to $50 million with a minimum maturity of one year. Mandatory hedging requirements for infrastructure loans are to be reviewed. So also the cap of 20 per cent on any corporate group in foreign portfolio investors’ corporate bond portfolio. 

The government will seek to curb inessential imports (such as electronic items) and boost exports through incentives. Both are to be welcomed. We need import controls to check imports because key imports are price-inelastic. We need incentives to boost exports because with manufactures increasing in importance in our export basket relative to commodities, a big chunk of exports too is price inelastic.

All these are measures that will address the current account deficit and capital flows in the medium term rather than in the short term. They send out a signal that the government believes the exchange rate situation is under control.  

There is some concern that speculators are responsible for the depreciation in recent days. Not to worry. The RBI has a comprehensive view of positions in the forex market and is perfectly capable of decisive action to snuff out speculation. Should the external situation worsen, the RBI has an array of weapons in its arsenal: Issue of bonds to NRIs, bilateral swaps, tightening liquidity, raising limits for external commercial borrowings, direct provision of forex to oil companies etc. 

India’s economic fundamentals are in far better shape than in earlier emerging market crises. The RBI might want to use its newly started SMS service to ask citizens not to allow the fall in the rupee to dampen the festive season — as long as they don’t rely on  private transport.

The writer is a professor at IIM-Ahmedabad 

ttr@iima.ac.in