Even though the depreciation pressure was sudden, the first plausible reason why RBI could have stayed out of the market was that the depreciation was more fundamental than speculative in nature. The current account deficit for India remains wide and the trade deficit has been rising recently, despite the sharp growth that the export side was exhibiting. However, there was a significant period of time over which the rupee had remained ranged at 44-46 to a dollar. It even showed some appreciation bias between end-May and end-July, 2011.
And then all negative news from the global arena came together, which determined the depreciation bias for the rupee to a very huge extent. First, there was the downgrade of the US from its long-held AAA status and the August 9 FOMC meeting that announced holding policy rates at the 0-0.25% level till mid-2013. This clearly started off the risk aversion process in the global economy and a flow back to the safe haven of the US treasury bills. Subsequently, the rumblings from the European side had also started off, with questions being raised on Greece being able to meet its fiscal obligations in order to obtain the next round of funding from the EU or IMF to repay debt. Further, there were concerns that the contagion could spread much more rapidly than was earlier anticipated. On August 31, the FOMC minutes of its August meeting revealed that the committee members remained quite downbeat on the economy, implying more risk aversion.
Thus, it was clear that the depreciation of the rupee was based on global developments. While this sharp depreciation could be detrimental to the fight that RBI is currently putting up against domestic inflation, it has still preferred to stay outprobably with the understanding that it could be extremely costly to prevent depreciation bias in the face of the global developments. And what is revealing is that for the first 20 days of September, the cumulative net FII flows into India are positive while Asian countries such as Korea and Taiwan witnessed heavy outflows. Thus, any significant sale of dollars by RBI (as was done by the Korean central bank to stabilise the won) would probably have sent a wrong signal to the market, that RBI was fighting against significant outflows.
And finally, by far the biggest reason why RBI might have wanted to stay out of the market is the need to keep their gunpowder dry, in the event of a meltdown in the global financial markets. During Lehman, in a single month of November 2008, RBI had to sell $18.7bn to fight against outflows. And this time, given the dimensions of the problem and a weaker crisis-fighting power of central banks globally, the outflows could be magnified.
The author is Chief Economist,
Kotak Mahindra Bank.
Views are personal
Containing volatility has been the stated exchange rate policy of RBI for a long time. But the intervention strategy revealed in the monthly forex intervention data tells a different story. From 2009 onwards, intervention by RBI has been almost non-existent while intervention happened almost every month in 2007 and 2008. Part of this difference could be due to a dwindling balance of payments surplus. But preference for a more market-determined exchange rate could also be behind a hands-off approach.
A non-interventionist stance might be appropriate in an orderly exchange market. But in extremely volatile markets there is merit in intervention, to keep the range of currency fluctuations narrow. In the current context, there could be 4 reasons why RBI might consider active intervention.
First, a rapidly depreciating currency can nullify the benefits of any global commodity price correction, amplify imported inflation and force more interest rate hikes. In fact, most academic studies find that in India 10% depreciation in the currency leads to inflation going up by 60-200 bps over the medium term. It is sometimes argued that the positive effect of currency depreciation on export competitiveness neutralises the negative pass-through effect on inflation. Unfortunately, most Asian currencies have fallen in tandem and the relative value of the rupee against a basket of currencies is near a neutral level. So, although the rupee has depreciated sharply against the dollar, competitiveness of our exports might not have improved much. We would hasten to add that a case for intervention on these lines can be made only if currency depreciation sustains for a considerable period of time.
Second, sharp and unpredictable currency moves can affect corporate balance sheets. This is particularly important as outstanding external debt of the private sector has increased from $59bn in March 2008 to $87bn in March 2011. The trend to dollarise the balance sheet has continued strongly even after that, to take advantage of the lower interest rates abroad. If part of this currency risk has not been hedged, then a rapid rupee depreciation might impact corporate performance. And companies have about $84bn of external debt maturing in FY12.
Third, unfettered currency depreciation can generate expectations of more depreciation and become a self-fulfilling prophecy. If RBI is thought to be the central bank allowing maximum free movement of currency, then speculators might express that view in the offshore market by selling more rupees relative to other emerging market peer currencies where central banks have actively intervened.
Fourth, large fluctuations in the currency market create uncertainty in the business environment. And when investment activity is already slowing down, an added source of uncertainty could be avoided.
The philosophy of letting the currency float is a noble one, but exceptional circumstances warrant deviation from this strategy as the Swiss National Bank has shown us recently. If the worsening of the European crisis precipitates more currency depreciation, then RBI should be ready to act. The kitty of forex reserves is large enough to make the intervention effective and the adverse consequence of worsening onshore rupee liquidity could be tackled by other liquidity infusion mechanisms.
The author is Regional Head of Research, India, Standard Chartered Bank. His column is coauthored with Priyanka Kishore, FX Strategist at the bank