Agile approach

Rupee should be allowed to adjust to lower levels

A key element in maintaining financial and macroeconomic stability in a developing country with a persistent current account deficit is stability on the external front. Recurring sharp currency movements can make it more challenging to maintain macroeconomic stability, and affect business confidence. In this regard, after the shock of 2013 — the taper tantrum episode — which led to a near currency crisis, the Reserve Bank of India (RBI) has managed the external accounts fairly actively. It has built reserves in times of excess capital flows and used them in relatively difficult times to avoid excess volatility in the currency market. The RBI, in this context, besides other methods of communication, releases a half-yearly report on foreign exchange reserves. The report for October 2023-March 2024, released this week, showed reserves increased from $587.71 billion in September 2023 to $646.42 billion at the end of March 2024. It has declined marginally to about $642 billion since.

On a balance-of-payments basis, India’s reserves increased by $32.9 billion during the April-December 2023 period. In terms of adequacy, these were worth 11 months of import, compared to 10.4 months at the end of September. A large part of reserves is kept in foreign currency assets. The RBI has also increased its gold holdings from 7.37 per cent of total reserves in September to around 8.15 per cent at the end of 2023-24. Fluctuations in foreign exchange reserves, besides valuation adjustments, are essentially a result of market interventions by the RBI. Since the interventions are on both sides, they have resulted in relative stability of the rupee. The currency has depreciated by just about 1.5 per cent over the past year.

Given that India has been witnessing surplus flows over time, non-intervention by the RBI could have resulted in significant appreciation of the rupee, affecting the competitiveness of the tradable sectors. The trade-weighted 40-currency real effective exchange rate (REER) was overvalued by over 4 per cent as of March 2024, though export-weighted REER was overvalued to a lower extent. Since foreign portfolio investors have been net sellers since April, partly because of election-related uncertainties, the rupee can be expected to depreciate, which will help correct real overvaluation. The RBI will be well advised to allow this adjustment to take place. Besides, while India’s current account deficit is at a comfortable 1.2 per cent of gross domestic product (October-December 2023), it could increase as the pace of investment picks up to support medium-term economic growth.

Although India has a strong external position at present, corrections in the medium term are required on both current and capital accounts. On the current account, India needs to improve its export competitiveness, which will not only help reduce dependence on foreign savings but also boost employment creation and overall economic growth. Since the relevance of the World Trade Organization has diminished over the years, India will need to find ways to remain relevant in the changing global order. On the capital account, since India has now accumulated large reserves, it should aim to reduce the dependence on short-term volatile flows. To be sure, some volatile inflows will be unavoidable, given the very nature of portfolio flows. According to the RBI numbers, however, volatile capital flows were worth 70 per cent of reserves in December 2023. While this decreased from 73 per cent in September, a sustained reduction will help strengthen the external position.