What is wrong with a sharp rupee depreciation The first concern is about inflation. India is now deeply integrated into the world economy. A lot of things that we import are priced in US dollars, and a rupee depreciation would worsen inflation. In addition, a lot of domestic productssuch as steelare priced by import parity pricing where the global price is multiplied by the rupee-dollar exchange rate in order to arrive at the price used in purely domestic transactions. Through these two channels, the rupee depreciation might kick up inflation in India. However, at the same time, a sharp softness has arisen in world prices owing to the economic downturn that appears to have begun in late September. In the US, expected inflation that is visible from the market for inflation-indexed bonds the best forecaster of future inflation is showing that inflation will drop to around 1%. A series of prominent commodities such as oil, wheat, etc. have had dramatic price falls. These declines in dollar prices more than compensate for the 19% rupee depreciation. Worries about inflation thus do not motivate doing anything about the rupee-dollar rate.
Towards managing risk better
The most important issue is that in difficult times, market prices must be allowed to adjust. Suppose the Indian government artificially props up the rupee dollar rate. Suppose the true rate should be at Rs 55 a dollar but the RBI exerts itself mightily and manipulates the market so as to deliver Rs 45 a dollar. This will require selling roughly $25 billion out of reserves, month after month. When the private sector sees this, they will realise that this distortion of the exchange rate cannot be kept up for long. The rupee-dollar rate will, sooner or later, have to find its true level with a 22% depreciation leading to Rs 55 a dollar. This will set off a massive scale of asset sales in India. Locals and foreigners will sell assets to get money out of the country, to profit from taking money out at Rs 45 and then bring it back at Rs 55, thus earning a 22% profit. Land, shares, companies, factories, art: all kinds of assets will be sold off in the rush to get out while the government is giving a good deal. In this fashion, exchange rate management will convert a difficult situation into a full blown financial crisis.
For this reason, the wise course in India today is to allow the rupee to float. At every point in time, the private sector must see a two-way bet. The private sector should feel that there is a good chance that the rupee will appreciate and that there is a good chance that the rupee will depreciate. The private sector should never see a one-way bet where the rupee is expected to only move in one direction. High currency volatility is a new experience for everyone in the country. The way forward lies in giving every household and every companyand even the governmenta way to better manage that risk. Currency derivatives are a tool of choice for this purpose. Instead of the government putting out a public sector umbrella of risk management covering the entire economy, it is more efficient for each person to buy an umbrella that covers his own needs. The way has been shown by the remarkable success of currency futures trading at NSE, which has crossed Rs1,000 crore of turnover per day within less than two months. This is despite this market being hobbled by five constraints: a ban on FIIs, a ban on NRIs, a ban on currency pairs other than the rupee-dollar, a ban on derivative products other than futures and a ban on positions exceeding 6% of the market wide open interest. These impediments need to be eliminated, so as to create the framework of financial markets through which India can transition into a floating exchange rate.