External stability

New challenges can emerge in currency management

One of the most remarkable features of India’s economic management in recent years has been stability on the external front. This is important because India runs a current account deficit and depends on global savings. Although the recent tightening of global financial conditions because of a sharp and coordinated increase in policy rates by large central banks did create some pressure on the external front, the impact was contained and short-lived. In fact, the handling of external accounts over the past few years prompted many analysts to draw comparisons with the taper tantrum episode of 2013, which pushed India to a near currency crisis. The conditions, however, are very different now. The rupee touched a six-month high against the dollar this week and is roughly at the levels seen a year ago.

While there are a number of supporting reasons for the stability and strength exhibited on the external front, such as overall macroeconomic management and the growth outlook, the handling of capital flows by the Reserve Bank of India (RBI) in recent years has played an important part. As large central banks across the world flooded the system with liquidity to control the damage caused by the pandemic-induced disruption in 2020, India received large capital flows. Instead of allowing it to push up the rupee, which would have affected India’s tradable sectors, the RBI intervened in the currency market and accumulated foreign exchange reserves worth about $120 billion in 2020. The reserve accumulation proved useful in stabilising the currency at the time of global tightening. Foreign exchange reserves declined by over $100 billion between January and October 2022. In the absence of large reserves, it would have been a lot more difficult to manage the external sector at that time. A comfortable position on the external front also provided policy space domestically and allowed the government to run a large fiscal deficit.

However, now that policy tightening in advanced economies has peaked and the RBI has also roughly regained the reserves, it may need to refine its approach to currency management. The International Monetary Fund (IMF) in its country report in December 2023 termed India’s exchange rate regime a “stabilised arrangement” instead of floating. The stated policy of the RBI is that it does not target any level in the currency market and intervenes only to check excess volatility. The accumulation of large reserves is also aimed to protect external stability in times of stress as was witnessed during the recent tightening episode. But as things stabilise, the RBI may need to reassess its position. Given that inflation rates in advanced economies have come down significantly, the expectations of rate cuts, particularly in the US, will result in higher flows to emerging markets. India could attract more portfolio capital because of its position as one of the fastest-growing large economies.

Indian government bonds are also being included in global bond indices, which will increase flows. Not intervening in the market will lead to an appreciation in the rupee. However, sustained interventions and accumulation of reserves can attract even higher flows because the currency risk for both foreign investors and domestic borrowers would come down incrementally. A sustained accumulation of reserves can also have other implications. It can affect both fiscal and monetary policy operations. The external sector thus would require deft management even as global financial conditions normalise in the coming quarters.