After repeated episodes of currency turbulence during the past three years, some stability appears to have returned as far as the rupee is concerned. It is more than 30 per cent below its peak in mid-2011, a drop that most would agree was both necessary and welcome. High inflation and low productivity compared to other emerging market economies had caused the real effective exchange rate (REER) to appreciate sharply, which significantly eroded the competitiveness of Indian producers. The short-term correction for this would have been a depreciating currency; in the long term, productivity improvements are the only solution. However, as a result of steady capital inflows after the global economy seemed to have recovered from the financial crisis in 2009, the rupee did not depreciate, thereby perpetuating the pressure on the current account deficit. This was subsequently hugely intensified by the drop in iron ore exports and the increase in non-coking coal imports. As the current account deficit surged and capital inflows were interrupted, the rupee fell rapidly and has now reached a point where the REER is relatively less hostile to export competitiveness. This is partly reflected in the narrowing current account deficit.
But what lies ahead for the rupee? The recent stability, even mild appreciation, is the result of a combination of factors. The narrower current account deficit is an important one, but there have been significant increases in capital inflows, almost exclusively into financial instruments, both equity and debt. There is a widespread view that this is being driven by the prospects of a stable and dynamic government being voted into office in May. Indeed, several election forecasts point to this. But accuracy has rarely been a strength for Indian forecasts; policymakers have to factor in the risks posed by other possible scenarios. For example, if a Third Front formation is to emerge out of a hung Lok Sabha, all those inflows may reverse very quickly and the rupee could see another sharp drop, made worse by the likelihood of a fragile and short-lived government, with little capacity to address critical challenges. The financial regulators will have to play a central role in dealing with such a situation. The Reserve Bank of India (RBI) must bolster its capacity to do so when it has the opportunity, as is currently the case. It needs to buy up dollars as they become available in the market, genuinely enhancing reserves, as opposed to the swap facility that was offered to banks a few months ago, which merely increased them temporarily.
Obviously, one consequence of this will be to prevent the rupee from appreciating. For people who see a floating exchange rate regime as the appropriate one, including RBI Governor Raghuram Rajan himself, this may seem like anathema. But operating in an environment that is fraught with risks - both external and domestic - requires pragmatism and flexibility. Allowing the rupee to find its level may work in less uncertain times, but in the current circumstances, the risks of financial instability brought about by capital flight justify a departure from this position. It wouldn't hurt if, in the process, the REER, which is already showing the impact of some other emerging market economy currencies depreciating while the rupee moves the other way, remains favourable to competitiveness.
