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Reserve Bank of India’s governor D Subbarao explains the reasons for the recent liquidity tightening measures at the post policy press conference and explains the central bank’s staretgy on the exchange rate: Excerpts:
Rationale for liquidity tightening measures in the last two weeks
The current account deficit in the last three years has been above the sustainable level. The rupee should have depreciated on the consequence of the high current account deficit. In other words, depreciation was programmed into the rupee. That did not happen because we were able to finance the CAD and we were able to finance because of extra-ordinary liquidity in the global system.
Because of the large current account deficit and because of the way we financed it, we became vulnerable to external outlook, we became vulnerable to financial markets and we became vulnerable to sudden stop or reversal of capital flows in the consequent of the stabilization of the exchange rate.
The only unknown was when it might happen and the vulnerability came sooner than everyone in the world expected. The rupee dropped from 57/$ to 61/$ in a matter of four weeks without any change in our fundamentals. There was 5.8 per cent depreciation on May 22 when the first announcement was made (by US Fed) and July 26 – the last Friday.
This rapid depreciation of the currency put us in a vicious spiral, amplify unidirectional movements and encouraging a hurting instinct. On top of the rupee movement there was very comfortable liquidity in the system. On July 5, LAF went to a reserve repo mode briefly. So, the easy liquidity provided fertile ground for speculation on the exchange rate.
When we were having a meeting with the technical advisory committee last week, one of the members said what is vulnerability? Vulnerability is if something goes wrong then suddenly a lot goes wrong very quickly. That is what happened to our system. So, we determined the volatility in the exchange rate hurtful to the economy for a number of reasons.
First, if the exchange rate overshoots, it may not come back to the original level, it stays there. So it is very important for us to see that the adjustment took place in line with fundamentals. Second, a rapid depreciation of the exchange rate would have impacted the balance sheets of banks, corporates, and even households.
Intervention in foreign exchange market
Forex intervention is a standard tool for defending against volatility. As much we resorted to that instrument, we were also conscious that whatever we did should not fuel speculation. The first standard of defence against excessive exchange rate volatility is monetary policy instruments.
We want to mention that we were not altering the fundamental path of exchange rate. Our action was entirely for the need to curb volatility and disorderly movement.
When and how to roll back
We did not use the word the temporarily, advisably. Because, tempprary would mean different things to different people. And you would pressure us to define temporary and we were not in a position to define what temporary was and in the event we would have created more confusion than through light.
The rollback of the measures will be stake contingent and data dependent. And is linked to decline in volatility and disorderly movements in the exchange rate. Some of the indicators we will look at is bid—ask spread, the intraday volatility in exchange rate, volumes of forward contract, to evaluate importers’ assessment regarding the stability of exchange rate, volumes and open interest position in the currency futures market, forward premia and a number of other indicators.
We will also make an assessment of the global markets and see how vulnerable they remain to further announcement or some action.
There has been a lot of speculation in the market that RBI is targeting a exchange rate. That speculation is completely misinformed. We are not defending any exchange rate target and not altering the movement of exchange rate according to fundamentals. What the RBI wants is to reduce the volatility and orderly adjustment of exchange rate to its market level.
Finally, I want to say that RBI is sensitive to the short term costs of tight liquidity measures to economic activity. And we are as anxious as everyone else to roll this back. But getting locked into a time frame is both infeasible and inadvisable.
On rupee slipping after policy announcement which was seen as dovish
We don’t make a determination of whether to sound dovish or sound hawkish. We are not targeting any level of rupee, if the rupee is adjusting gradually, then that is the way it should be. As far as the broader monetary policy stance is concerned, there would have been reasonable arguments for further monetary easing because growth has moderated more than we expected and inflation is not as uncomfortable as before as much as there are risk factors.
That is the reason behind the language. So there would have been a case for monetary policy easing but for the external sectors concerns (it was not done). I would like it to be read as the importance RBI is attaching containing exchange rate volatility.
If more steps likely in case rupee depreciates further
I cannot comment on that. It is not about rupee depreciation per se, it is the volatility that we will be looking at. So, the level is what you should be looking at.
