A slowing economy with a wide current account deficit has limited policy choices in an uncertain global environment. It is no surprise, therefore, that Indian policymakers are also facing a short-term dilemma of whether to save the rupee or support growth. It is well understood that, in the long run, this dilemma will resolve on its own?measures to promote growth generally support the currency as well. However, in the short run, a trade-off is unavoidable.

RBI?s recent measures to stem rupee depreciation should be seen in the context of this dilemma. The central bank has generally followed a ?hands-off? approach in the currency market since the bout of rupee depreciation started in May. The extent of currency intervention and other measures has been small, and policymakers tried to explain that the down-move in the rupee is part of a broader emerging-market currency-depreciation story. However, the recent RBI measures present a very different approach to the issue.

There is now a clear acknowledgment by the policymakers that the rupee has overshot its fair value and can have a negative macro impact. This is in line with our view that sharp rupee weakness could reverse some of the recent macro improvements. Our estimates show that a weaker rupee can add to inflationary pressure, widen the fiscal deficit and slow capital inflows without having a positive effect on the current account deficit. Rapid rupee depreciation also affects business sentiment negatively, as uncertainty rises and worries about a possible financial crisis set in.

The measures also indicate that RBI?s monetary policy stance is not accommodative anymore. In fact, in the June monetary policy itself, RBI had introduced the need for balance of payments (BoP) considerations in its monetary policy guidance along with the traditional growth/inflation trade-off. It is clear that external-sector considerations are now dominating the central bank?s monetary policy stance. It probably thinks that at this juncture, on balance, the negative effects of rapid rupee depreciation outweigh the collateral damage to growth that could result from the recent measures.

Such strong measures were probably also necessary because RBI saw no quick-fix solution to India?s fundamental problems of a wide current account deficit and funding this deficit amid an uncertain global economy. In fact, the primary reason behind the recent sharp rupee depreciation was an external-event shock?fears of Fed QE tapering. It is unlikely that these measures would have the immediate effect of encouraging interest rate-sensitive debt inflows, because the fear of possible rupee depreciation still persists in the markets. However, one of the objectives of the measures could be just to provide some stability in the currency markets rather than trying to make the currency appreciate. Any such period of stability will provide the policymakers space for more reforms to address the fundamental challenges. The government announced the relaxation of FDI rules in several sectors immediately after RBI announced these measures. The stability of the exchange rate will be an essential precondition if the government wishes to issue a sovereign bond in the near future.

Exchange-rate management is also about expectation management. India?s macro fundamentals, though weak, were not worrying enough to prompt a run on the currency. However, market expectations were indicating that the rupee could be in a free-fall. Expectations of a weaker rupee were, in turn, leading to expectations of macros being hurt and further supporting weak rupee sentiment?it was like a vicious cycle of expectations. Thus, to curb fears of further rupee depreciation, RBI likely felt the need to take strong action that would have the immediate effect of breaking this expectation spiral. Also, the severity of these measures would alert markets to RBI?s strong resolve to arrest rupee depreciation.

The context and the responses are similar to 1997-98, when the rupee depreciated sharply following the East Asian crisis?an external-event shock. The outlook for capital inflows was bleak because of several domestic and external factors, and RBI took certain extremely strong measures to tighten liquidity and increase policy rates by 200 bps in January 1998. Overnight rates shot up to 65%, making it prohibitively costly to hoard dollars. Although this time RBI has refrained from using the CRR, its overall approach to tightening liquidity to stem currency depreciation broadly follows the 1997-98 episode.

However, these measures could result in collateral damage, owing to significantly altering the borrowing costs of banks, which would later be passed on to the rest of the economy. For example, if the banking system?s liquidity deficit is R1 trillion, banks will have to borrow R250 billion under the marginal standing facility (MSF), and their weighted-average borrowing costs will go up by 75 bps. In this example, RBI?s announced measures are equivalent to a 75 bps increase in the repo rate.

The impact on growth and other real-economy variables will also critically depend on how long these measures remain in place. The authorities are trying to stress that these unconventional measures are temporary (the permanent tools?the repo rate and the CRR?were not used), but the markets are still quite uncertain about their duration. After taking such strong measures to defend the rupee, RBI is likely to wait for expectations of rupee depreciation to subside. As an extreme step, RBI may even keep these measures in place until it gets clarity on market reaction to Fed QE tapering. Removing the measures too early may not have the desired effect on currency markets, and their staying too long could push us a long way back on growth. We think that these measures may remain in place for anywhere between one to six months. While the measures are in place, RBI is likely to control the severity of their impact by adjusting the liquidity deficit through different measures including OMO sales and, probably, a CRR hike.

RBI has acted decisively; however, a sustained tightening of domestic liquidity conditions is a rather indirect way of calming FX markets. In fact, the initial reaction has been more pronounced in the interest rate market than the currency RBI market. If these strong measures are not complemented by equally determined efforts to tackle the current account deficit and improve conditions for more stable capital inflows, or if global conditions driving those inflows to emerging markets deteriorate, we might end up achieving only a slower pace of depreciation, not a reversal in trend. We are also now exposed to the risk of even slower growth prompting equity outflows and putting pressure on the currency. We are entering a phase in policy making where flexibility to address the evolving macro dynamics would be critical. If conventional macro theory does not work because of the peculiarities of the Indian markets, there is no harm in trying differently.

The author is managing director and regional head of research, South Asia, Standard Chartered Bank