But it is worth pointing out a few things. One, that the rupees volatility had already declined significantly even prior to the RBI move on July 15. Two, that the rupees rise during these 10 days could well be part of a general dollar depreciation against all major currencies and so may not really reflect victory on part of RBI. During the same 10 days, when the rupee appreciated by 1.3% against the dollar, the euro appreciated by 1.6% and the South African rand rose by 2%. Could it just be that the rupees woes would have ended without RBI sucking out the liquidity that has exposed the corporate and banking sector to severe downside risks.
RBIs actions have resulted in quite a bloodbath for bond holders with yields on 10-year securities going up by more than 70 basis points and call money rates climbing by as much as 315 basis points to 10% by July 25. The resultant liquidity crunch has sharply increased the vulnerability of companies dependent on bank credit for their working capital requirements. We should not be surprised if the banking sector sees a rise in non-performing loans in the coming period. Rising interest rates will surely discourage fresh investment and capacity expansion further stifling growth impetus in the economy. This at a time when growth is already down to 4.8% and headed downwards as reflected in the marked slowdown in non-agriculture credit off-take and net capital outflows from the country with domestic investors now actively pursuing opportunities abroad.
One is left to wonder about the reasons that pushed RBI into measures that will push growth down further.
RBI could not have been trying to peg the rupee to any predetermined value level. No central bank (except perhaps the Peoples Bank of China with its foreign reserve horde of more than 3 trillion dollars) can afford to take on the market. That is simply a lose-lose strategy and RBI knows that.
Was the rupee actually in danger of a free fallthere was media chatter of its catching up with ages of the finance minister and then of the Prime Minister and the Opposition was clearly piling on the pressure. Could it be that the government pressurised RBI to avoid further political embarrassment One hopes not.
If GDP growth declines further (a distinct possibility) and the uncertain investment climate and unclear tax (transfer pricing) policies continue to discourage FDI inflows and fresh investment, the rupee will resume its downward slide and RBIs growth reducing measures would have been in vain.
Another reason being suggested is that RBI wanted to avoid the huge foreign exchange losses which some firms would incur on the unhedged part of their external commercial borrowings. Actual estimates are not available but it seems that nearly half of external commercial borrowings by Indian firms are unhedged and a further fall in the rupee would expose them to unbearable losses and possible closures. On the other hand, the liquidity crunch now being faced by firms with large domestic debt could face higher debt servicing obligations that could prove unsustainable. RBI was faced with a Hobsons choice and has clearly preferred to bail out those who borrowed abroad. One wonders why
A major reason for the intervention could be the fear that a depreciating rupee would stoke inflationary pressures. With retail inflation still hovering around double digits, RBI could not risk a a sharper rupee depreciation resulting in higher import prices for petroleum products, coal, fertilisers and capital goods. The usual assumption in this case is that these necessary imports are price inelastic and so would simply add to the burgeoning current account deficit. An eventuality RBI could not allow to happen. However, the decline in imports in June 2013, the continuing negative numbers for autos and other consumption items clearly indicate that with the slowdown in economic growth, domestic demand has pretty much collapsed. With declining imports, even a depreciated rupee would contribute only marginally to inflation. The real culprits for retail inflation are food and cereal prices. Imports and their prices hardly have any role in this inflationary phenomenon.
The depreciating rupee would surely make exports more competitive. India has never given its exporters the advantage of a sustained period of an undervalued rupee. All estimates of real effective exchange rate point to the equilibrium value of the rupee being very close to 60 to a dollar and so there is little economic reason to get nervous attacks if it goes below 60 and stayed there for a while. Our policy makers, including our central bank, have to make up their mind whether they want the share of Indian exports in global trade to increase from its present dismal level of about 1.8%. The ministry of commerce would do well to raise a much louder voice against all those who argue for a stronger rupee whether inside or outside the government.
So, what has RBI achieved At best a temporary reprieve for the besieged rupee Engineering a liquidity crunch is hardly the advisable remedy to break out of this siege. The costs can be just too high in terms of lost growth, severe dampening of investment sentiments, killing off the animal spirits and making our exports less competitive. The alternative set of steps could be, for example, to slash the number of clearances required to start and carry on business. To announce a liquidation of the 70 million tonnes of food stock, half of which are left to rot in the open, to bring down market prices of foodgrains and shelving the Food Security Bill. These may have a better chance of bringing back investment, improving growth prospects and lowering inflation. RBIs unprecedented market intervention to shore up the rupee may have brought temporary relief but with high downside risks.
The author is senior fellow, Center for Policy Research, and senior Wadhwani fellow