Arresting rupee volatility: RBI's policy conundrum

In the current financial year, the rupee depreciated against the dollar by around 8 percent. Such a massive downfall in the rupee in a comparatively short period of 5-6 months has certainly put pressure on RBI Image: Shutterstock
 
Amidst the current milieu of enduring stagflation, the uncertainty created by the war between Russia and Ukraine and the rise in interest rates in the US, the Indian currency depreciated to a level never seen before. On September 28, 2022, the rupee breached the level of Rs. 82 per dollar before recovering slightly on September 29, 2022, to settle at around Rs. 81 per dollar. In the current financial year, the rupee depreciated against the dollar by around 8 percent. Such a massive downfall in the rupee in a comparatively short period of 5-6 months has certainly put pressure on RBI. The incessant fall in the rupee entailed the RBI intervening in the foreign exchange market to arrest the volatility in the Indian currency. As per the WSS data, RBI has intervened in the FOREX market to the tune of $19 billion in the last month. Also, India’s FOREX reserves in July 2022 are sufficient to cover the import of around just seven months, as against 12 months a year ago.

Theoretically, a falling rupee will act as a boon for exporters who will realise more Indian currency in exchange for a US dollar. However, given the relatively inelastic demand for Indian exports abroad, the realisation of such benefits to exporters is in question. On the other hand, rupee depreciation will act as a bane for importers as importers will have to shell out extra money for their imports. Subsequently, it will adversely impact India’s trade and current account as well as the overall BOP situation.

US interest rates have certainly played truant in a crucial way. To tame the persistence of elevated headline inflation in the US, the US fed fund rates have been hiked massively by 275 basis points in 2022. These interest rate hikes have contributed to capital outflows from India and also from other Emerging Markets and Developing Economies (EMDEs) and Advanced Economies (AEs). The US policy impacted the interest rate differential, which in India is evidenced in a decline in the USD vis-à-vis INR forward premia. In September, the forward premia declined from a range of 3.24-2.98 in August to a range of 2.96-2.74 pointing towards a negative impact on capital flows. As per BOP data released by RBI on September 29, 2022, India’s current account deficit (CAD) has shown a rise of around 78 percent on a Q-o-Q basis while foreign portfolio investment registered a net outflow to the tune of $14.6 billion to Q1 of 2022-23. In this context, it is interesting to note that widening CAD and reduction in commensurate capital inflows has led to fewer FOREX reserves as compared to the previous quarter.

Against this backdrop, the Monetary Policy Committee (MPC) of RBI, in its monetary policy resolution announced on September 30, 2022, increased the policy repo rate (PRR) by 50 bps. This increase in PRR, among other measures, is meant to provide leeway to RBI in managing exchange rate volatility in the short run. The steps taken by RBI through the MPC resolution will help in narrowing interest rate differentials between the US and India and attract more capital inflows. These steps will also improve India’s capital account situation and restrict the fall in precious foreign exchange reserves.

Also read: RBI fights daunting challenges with another 50 bps rate hike

However, at the current juncture, it is important to note that India registered a lacklustre economic growth in Q1 of 2022-23 and employment generation has also been bleak. Liquidity conditions are constrained as a result of the monetary policy tightening of the past few MPC resolutions. Tightening liquidity conditions are evident from the Weighted Average Call Rate (WACR) data, an operating target of monetary policy which hovered around 4 percent during the May 2022 MPC resolution and is currently at around 5.55 percent implying tight liquidity conditions. This tightening has the potential to bring about a reduction in aggregate demand and impact economic growth negatively. All this will certainly call for a review of the current aggressive monetary policy tightening phase by RBI at a certain point in time soon.

The current manoeuvring of policy interest rates cannot be relied upon extensively in exchange rate management over a longer period. Fluctuations in the policy interest rates will also have ramifications for other facets of the economy. It is a difficult road ahead for RBI in these choppy international waters with a highly volatile exchange rate primarily affected by exogenous factors. RBI must sail through these troubled waters unscathed and bring the Indian economy out of its currency pangs.
 
The authors’ views are personal.
Dr Preeta George Professor, Bhavan’s SPJIMR & Chinmay Joshi Academic Associate, Bhavan’s SPJIMR

[This article has been reproduced with permission from SP Jain Institute of Management & Research, Mumbai. Views expressed by authors are personal.]