Notwithstanding Mondays sharp firming up of the rupee, last weeks statement of the Reserve Bank of India governor Venugopal Reddy should keep expectations about a shift in the central banks policy stance on the rupee-dollar exchange rate under check. There has been a misreading of the RBIs apparent sanguineness on the rupees appreciation, with some viewing it as a change in policy stance. Once the RBIs market stabilisation fund becomes operational, it will be able to give more teeth to its policy of managing volatility while allowing the markets to set the direction of change. In the face of persistent capital inflows, which can ebb and flow with suddenness, market participants must get used to dynamic policy responses that are not only targeted but will be withdrawn once the clouds have blown. As far as dealing with inflows is concerned, these range from exchange rate appreciation, absorption into reserves and sterilisation, feedback into money supply, liberalisation of outflows and capital controls. Over the past one year, the national authorities have used a bit of all these. So there has been some exchange rate appreciation, some accumulation of international reserves, some monetary expansion, some liberalisation and some deterrence of short-term capital inflows. There is, therefore, an explicit recognition on their part that prolonged use of any policy response is unsustainable. If inflow surges are partly perceived to be temporary and potentially reversible, RBI will have to be adaptive in its response. It must also change track as and when the macroeconomic situation so warrants it, particularly because in an open economy several macroeconomic variables must be juggled and balanced. In the instant case, it is obvious that the trade-off is between inflation and exchange rate appreciation, so a bit of the latter is tolerable for some time since there is renewed anxiety about the former.
That the exchange rate must bear the entire burden of adjustment, as some critics persistently argue, is an unlikely policy choice for India for a long time to come. Financial and capital account liberalisation all over the world has been accompanied by macroeconomic instability, boom-bust cycles and rush of inward capital followed by sudden reversal. Of course it is important to reckon with the composition of capital inflows, which is dominantly portfolio equity capital. This is unstable, largely driven by the interest rate cycle and thus prone to sudden reversal; only the foolhardy would risk temporary adjustments in the exchange rate to accommodate such inflows. More to the point, Indias banks are not yet strong enough to withstand volatile capital movements. Sensibly, the RBI has been containing volatility and has been careful to avoid any serious misalignment. Depending on the movement of interest rates abroad, which are expected to harden during the coming months, there may be some respite for policymakers. But if the flow continues unabated, we might see some temporary repelling of short-term capital movements. The central bank has the armoury for any such attack and is equipping itself with a new fund that will kick in next week.