The rupee?s depreciation ? it hit a near two year low on Wednesday ? has seen the new RBI governor saying market intervention will not be reactive and regular but restricted to combating very high volatility. This is an important and positive change. But the real test of this policy is not now but as and when the rupee appreciates again. That?s a longer term question of course but immediate response to depreciation can also be reformist. There were restrictions put on foreign capital inflows when the rupee was appreciating last year; the argument being that inflows were putting too much pressure. That argument was flawed because the rupee should not have been regularly and reactively manipulated. But now that the rupee is going down, restrictions on external commercial borrowings and participatory notes should have no basis whatsoever. Removing those policies will be a good change and it will make India a better destination for inflows when market sentiments change; remember the fundamentals of the India story haven?t been affected by the current financial volatility.
For the long term reform ? minimal rupee manipulation in all conditions ? the political economy of currency change has to be understood by politicians. What do politicians want? Least hassle for most people. A depreciating rupee pushes up prices domestically but helps exporters earn more. An appreciating rupee does the opposite. Everyone knows, there are more consumers than exporters. So why do politicians favour exporters and want RBI to intervene when the rupee appreciates. Part of the answer is that economically literate exporters are better lobbyists than defused mass of voters. But there?s a more fundamental reason. India?s import basket is dominated by, apart from oil, raw materials and capital goods. Oil prices are rigged. So depreciation-induced higher oil import prices don?t directly affect voters. And depreciation-induced higher prices of raw material/capital goods are not felt directly by voters either. Consumer prices are affected after sometime and no one really pins the blame on currency changes. So politicians are not sensitive to depreciation?s inflationary effects but are vulnerable to export lobbies. Exporters however now have the currency futures market to hedge against rupee movements. Therefore, politicians can deny them protection. If politicians then understand what depreciation does to prices, may be India?s rupee policy can change.