We should not be fixated on the dollar exchange rate of the rupee, for the greenback is not a fixed yardstick. From March 2008, when Bear Stearns died, and particularly after September 2008, when Lehman Brothers died, something very peculiar happened. Instead of the dollar losing ground, it appreciated sharply. When international investors felt worried about financial firms and governments worldwide, they moved money into US government bonds as the ultimate safe asset. This ?flight to safety? pushed the dollar up at a time of the worst financial crisis in the US in over 50 years.
By mid-2009, the worst of the financial crisis was clearly behind us. With this, the motivation for the ?flight to safety? subsided. Now, to a considerable extent, we are back to the old story of a substantial dollar depreciation being required in order to get the US current account balance down. This decline of the dollar has begun.
At present, RBI tries to reduce rupee-dollar volatility. In the process, whenever the dollar loses ground, RBI is fighting appreciation, and whenever the US dollar gains ground, RBI is fighting depreciation. In other words, when the dollar falls, interest rates in India tend to go down, and whenever it rises, interest rates in India tend to go up.
RBI?s pursuit of stability of the rupee versus the dollar leads to a policy that destabilises the domestic economy. A better strategy for RBI is to think about India and only India when it comes to monetary policy.
The rupee-dollar rate will fluctuate, and the way to address concerns about currency risk is to permit the emergence of proper currency derivatives markets.
