RBI’s attempt to manage currency could prove to be a costly mistake

The central bank has drawn a line in the sand on the level of the rupee. And given the scale of its interventions in the currency market, it seems determined to defend the current levels. The numbers involved are staggering.

At the beginning of this calendar year, India’s foreign exchange reserves stood at around $633 billion. But, by the beginning of September, the reserves had dipped to $553 billion — a drawdown of almost $80 billion. Some of the decline is on account of the revaluation losses — with the euro weakening against the dollar, portfolio diversification towards the euro would have led to sizable investment losses. The balance likely indicates the extent to which the RBI has stepped into the currency markets to date.

But the pressure on the rupee to depreciate is unlikely to abate due to two factors. One, the strengthening of the dollar. The dollar index, which measures the strength of the greenback against a basket of six currencies (the euro, yen, pound, Canadian dollar, Swedish krona and Swiss franc), is at a 20-year high. Currencies of emerging market economies have also fallen in line. With the US Federal Reserve expected to continue to aggressively tighten — the recent inflation data seems to have reinforced this view — this trend is unlikely to reverse. And two, the country-specific factor of a deteriorating current account deficit. With export growth collapsing and imports continuing to remain sticky, the current account deficit, as per some estimates, is likely to be just shy of levels last seen during the crisis of 2013, exerting downward pressure on the currency.

In such a scenario, it is prudent to ask: To what extent can the RBI continue to deploy its reserves to defend the currency? Considering the scale of the drawdown — in just the week ending September 2, foreign currency assets fell by around $7 billion — what if over the course of the next few months the forex reserves continue to deplete at a similar pace? Will some form of capital controls and financial restrictions form the next line of defence?

Perhaps a more appropriate question to ask is whether the RBI should be defending the currency at all.

If there is one lesson from the past currency crises it is that in macroeconomics, “this time” is never different. There is an impossible trinity — an economy cannot have an independent monetary policy, free flow of capital and a fixed exchange rate. It must choose. Moreover, implicit in the defence of the rupee is the notion that the central bank knows what the true level of the currency is, not the markets. One would have thought that past follies would have rid us of this notion. Perhaps a loss of institutional memory is to blame.

A currency defence will also impose costs on the economy.

Since last year, the Indian economy has benefited from an export boom. Exports of goods and services grew at a staggering 36 per cent in 2021-22 as governments and central banks in the developed world pursued extremely accommodative policies to shield their economies from the fallout of the pandemic. However, this sharp surge has now come to a sudden stop with demand in developed economies weakening as central banks are now aggressively tightening policy to tackle surging inflation.

Allowing the rupee to depreciate during this period would help keep exports humming. Or at the very least maintain export competitiveness — the rupee has fallen less as compared to other currencies. Doing so may perhaps also bode well for domestic investments. But in the midst of a slowing growth momentum, and high current account deficits, the RBI is taking away the one advantage that the economy could have gained from the rupee’s weakness.

Some may believe that a stronger currency gives the impression of economic stability and generates confidence in the economy. But there is an inherent contradiction between artificially propping up the rupee and the country’s growth prospects. Very little economic gain will accrue from turning the currency’s value into a political issue.

Understandably, a depreciating currency leads to concerns over higher imported inflation. But inflation should be tackled through monetary policy, while exchange rate management should be linked to growth. Not the other way around.

However, it is true that inflation is far from being suppressed. While the RBI believes that price pressures will begin to ease in the second half of the year, the extent to which prices are rigid on the downside will become evident in the months ahead — inflation has already surprised on the upside in August. Pushing inflation down towards the central bank’s target may require high real rates. But statements from the members of the monetary policy committee seem to suggest that far greater priority is being attached to minimising the growth sacrifice than to preserving macroeconomic stability.

This is also where the political economy comes to the fore. With an export boom fading away, and with the economic momentum slower than was believed, inducing slack in the economy by aggressively tightening policy will be politically contentious. After all, as the national elections draw closer, growth considerations will begin to take precedence over inflation management.

ishan.bakshi@expressindia.com