Rupee defence strategy: Why RBI should embrace currency flexibility

In a series of recent pieces, we have been arguing that the just-ended Reserve Bank of India (RBI) regime made a radical change in exchange rate policy, which reduced export competitiveness and rendered monetary policy inappropriate for a slowing economy. And in the process the RBI’s intervention to prop up the rupee has led to a reserve loss of about $200 billion over three episodes, with over $50 billion lost since end-September alone. In this article, we want to go one step further, emphasising the serious risk this policy creates: The danger of a highly disruptive speculative attack against the rupee.

 

First things first. There can be no doubt that there has been a radical change of exchange rate policy. Figure 1 shows that whereas for years the rupee had fluctuated up and down in response to market pressures, the exchange rate has since 2022 become as flat as the pitch at the Melbourne Cricket Ground (MCG) in Australia — without the bounce of the green turf there. In other words, for the past two years, the RBI has essentially pegged the rupee to the US dollar. 

 

Now, there is an immutable lesson — almost an iron law — derived from umpteen emerging market crises over the last 50 years that countries which run a dollar peg for long periods become vulnerable to speculative attacks. And when these attacks occur, they can force extremely disruptive adjustments. Most famously, an attack against the East Asian pegs in the late 1990s forced major depreciations that bankrupted these countries’ major conglomerates (which had borrowed in dollars), as well as the banks that had lent to them. Their growth rates never truly recovered.

 

Ever since then, emerging market Central banks have tried to protect themselves by building up their foreign exchange war chests. India now holds about $650 billion in reserves, enough to finance nearly a year of imports. The problem is that global financial markets have even more firepower, as China discovered in 2015, when it lost over $1 trillion in reserves — yes, trillion with a “t” — defending its dollar peg.

 

But why would financial markets attack the rupee? Essentially, because the peg — indeed, any peg — has two large vulnerabilities. The first is that pegs inevitably lead to a loss in competitiveness. In India’s case, the average level of the real exchange rate has been 10 per cent stronger since 2019 than it was during the 1994-2018 period. And over the past few months, the problem has become worse.  As Figure 2 shows, ever since the US dollar began to appreciate in October, India’s major rivals have allowed their currencies to depreciate. So the rupee is in danger of becoming very overvalued, very quickly.

 

The second vulnerability arises because when the global tide of capital shifts, Central banks are forced to defend their pegs, subordinating domestic considerations to this objective. But this is very difficult for any country to do. A classic example came in 1992, when speculators realised that Britain had a conflict between its desire to maintain its peg to European currencies and its need to reduce interest rates to deal with an economic downturn. They concluded that eventually domestic considerations would be given priority. So they attacked, forcing the pound off its peg, putting paid to the country’s dreams of joining the (then-envisaged) euro.

 

In India, the problems are somewhat different but no less real. Consider the RBI’s dilemma. When capital first started to flow out of the country, the Central bank sold dollars to support the rupee. But these dollars needed to be bought with local currency, and when that happened domestic liquidity began to dry up, effectively tightening monetary policy and threatening domestic growth. 

 

This naturally worried the RBI. So it began to intervene in the non-deliverable forward (NDF) market, which operates entirely in dollars. But that was also problematic since NDF intervention is essentially a bet on the exchange rate. Say that the RBI takes a long-rupee position at Rs 85 per dollar, but when the contract matures the rupee is trading at Rs 87 per dollar. That means the RBI will need to pay out the dollar equivalent of Rs 2, which it takes from reserves, charging the loss to its capital.

 

Of course, in real life, the potential losses do not involve a few rupees but rather tens of billions of dollars. The RBI does not want to lose such large sums betting on the exchange rate, especially as it knows that its dividends are needed to plug the large revenue “hole” in the Centre’s budget. And that in turn puts a limit on the size of the bets that the RBI dares place in the NDF market. No one knows what that limit is. But investors do know that as of November the RBI’s long-rupee position in the NDF market was estimated by bankers to be a sizeable $65 billion. And they know that in December the RBI moved back to intervening in the domestic forward market.

 

But that move does not solve the problems, either. It merely postpones them, since forward transactions dry up domestic liquidity when the contracts are settled. The RBI could then respond by injecting new liquidity, but this is dangerous once an attack is underway, since it merely gives speculators the rupees with which to purchase even more reserves.

 

So spot, NDF or forward — all types of intervention have unwelcome side effects, creating limits on the extent to which the RBI is willing to intervene to support the currency. So, intervention will only work if the pressure on the currency ends before the RBI reaches its limits. 

 

It is possible that pressures will subside quickly. Perhaps global investors will soon conclude that the US stock market is overvalued, leading them to take their money out of dollars and deploy them instead in emerging markets. But even then there could be other triggers for pressures on the rupee: A re-assessment of India’s growth prospects; or of emerging markets as a whole — after all, China, South Africa, Brazil and others are all looking vulnerable; or something else altogether, like geopolitical developments. 

 

Investors know all this, and they take a view. If they decide that the stress will last a long time, exhausting the RBI’s limits, they will attack, with potentially serious consequences. 

 

In such circumstances, the safer alternative — the one chosen by virtually all other major emerging markets — is for the Central bank to take its hands off the reserves till. Instead, the RBI should respond to market pressure by allowing the rupee to decline, bringing it closer to equilibrium value and freeing monetary policy to focus on pressing domestic needs. Gradual decline is the best antidote to — or rather inoculant against — forestalling the more disruptive adjustment which can damage India’s hard-earned reputation for sound monetary and macroeconomic management 

 

To be absolutely clear, India today is not like the UK in 1992 or Thailand in 1997. But it would be unwise to ignore the risks when markets perceive that central banks’ defence of exchange rate pegs is unsustainable. The RBI should act immediately. Perhaps it has already started to let the rupee slip. And we would encourage it to go further and faster in the direction of rupee flexibility.

 

  The authors are, respectively, with the Madras Institute for Development Studies, JH Consulting, and the Peterson Institute for International Economics