As disgruntled corporate and bank treasury managers watched the Reserve Bank of India (RBI) refuse to unleash the full might of its war chest of foreign currency reserves to defend a sharply declining rupee last fortnight, the debate on the merits of active intervention by a central bank versus relative passivity was back on the table. A few clarifications are in order. RBI did intervene in dribs and drabs but if market rumours are to be believed (the amount of intervention by the central bank is notoriously difficult to fathom and hard data come only with a considerable lag), the cumulative amount of dollars sold for the days that it intervened was about $400-500 million. This is in contrast to, say, the Bank of Korea that was rumoured to have spent close to $3 billion to defend the Korean won that came under similar pressure.
Should RBI intervene more assertively if the pressure on the rupee continues, given the fact that it holds more than $300 billion in foreign exchange reserves? To be fair, RBI’s relative inaction was consistent with the stance that it has communicated a number of times to the markets — that it lets the currency float in a broad range, is perfectly happy with two-way movement and is not in the business of defending a particular level of the exchange rate. Its implicit message is that companies – exporters, importers and those who borrow in foreign currency – need to hedge their risks appropriately and cannot fall back on the central bank to guarantee their returns.
But consistency can often be the flip side of dogma. Is there a case, given current circumstances, to do a quick rethink on its stance on currency market intervention? First things first. There cannot be any doubt about the fact that the sharp fall in the currency has added yet another element of uncertainty to an economy already buffeted by the cross-winds of global turbulence on the one side and a highly unpredictable domestic policy environment on the other.
Besides, a rapid decline in the currency itself sets off a vicious cycle of retreating capital that triggers a further fall in the currency. For international equity investors, to take an example, last fortnight’s fall in the rupee was certainly a factor, apart from the general risk aversion, that drove them to dump Indian stocks and seek safer havens. Finally, there is the impact on inflation. Depreciation tends to be inflationary as the rupee price of each dollar worth of imports goes up as the rupee falls against the greenback. For products like petrol or fertilisers, prices for which are controlled, depreciation bloats under-recoveries and finally the subsidy burden. Each rupee of depreciation, for instance, apparently increases under-recoveries of oil marketing companies by Rs 9,000 crore.
All this might appear to constitute a somewhat watertight case for a more aggressive intervention. However, the issue is perhaps not that simple. The first question that one should ask in this context is whether intervention is likely to work at all. The jury is out on this. Let’s take last fortnight itself. The Bank of Korea might have spent much more in defending the won than RBI but it seems to have been less successful in stemming the currency’s loss. The Korean won was the worst performing currency in this episode, dropping by as much as nine per cent in this episode, compared to the rupee’s 6.5 per cent. The Indonesian central bank that spent much less (see table) was far more successful. The probability of success of intervention depends critically on the intensity of the pressure on the currency, on investor perception of an economy’s external fundamentals and so on. Trying to intervene when market sentiment is dead set against a currency could be a bit of a losing game. There is a large opportunity cost of using reserves and a central bank needs to assess the likelihood of the success of intervention before stepping into the market.
Second, while $300 billion or more might seem like a lot of money, it might actually not be “adequate” if the size and structure of our external balances are factored in. At the end of March 2011, India’s external debt stood at $305 billion and increased to $317 billion by June. Thus, the value of foreign currency debt is likely to be higher than our reserves, currently at $312 billion.
What is alarming is the fact that 43.3 per cent of this is “short term” by residual maturity, that is, about $137 billion need to be paid back over the next 12 months. Again, take the market capitalisation of the BSE-200 companies. It is roughly about $950 billion. Assume that about 20 to 25 per cent or about $200-250 billion of this held by foreign institutional investors and can leave the domestic markets in a period of extreme stress. Add this to the short-term debt repayment commitments and suddenly the $312 billion reserve figure doesn’t seem all that large. Central banks have to be prepared for what is now commonly referred to as a black swan event. This would involve a sudden stop in capital flows with redemption pressure on both debt and equity. Were that to happen, RBI would have to expend a large fraction of its reserves to prevent a run on the currency. Thus, it might make sense to be as careful about using reserves.
A couple of alternatives to this could work going forward. There is a case for managing the currency more actively when it is both appreciating and depreciating. In short, RBI should actively build reserves when the currency is appreciating and build enough of a buffer to fall back on when there is a sharp swing to the other side. The other is to intervene more strategically and manipulate market expectations to ensure its efficacy. Appearing to defend a level for the rupee might not be a bad idea after all and might just induce exporters to sell at that level, increasing the chance of successful intervention. Intervention might not always be a viable option for RBI but when it does choose to intervene, there are perhaps ways to make it work better.
The author is chief economist, HDFC Bank
The views expressed are personal
