The mini external sector crisis in May 2013, following the Federal Reserve’s taper remark, is still fresh in our memory. The shock tested policymakers’ nerves and debunked two popular myths: One, that India’s economy had developed significant resilience post-1991 balance-of-payments crisis and unlikely to face any external sector crisis, and two, the Reserve Bank of India (RBI) had built up sufficient precautionary forex reserves to fend off any pressure on the rupee. In the end, RBI could sell only $18.4 billion, or 6.3% of the total reserves in April 2013 ($294 billion), over May-August that year, inadequate to stop the rupee from depreciating sharply. It was realised, quite early on, that forex reserves built on capital account surpluses did not reflect the true external strength, that the rupee was significantly overvalued, and a correction was overdue.
On May 4 this year, as RBI Governor Shaktikanta Das rushed to announce a mid-cycle hike in the policy rate, the market was rife with speculation on what triggered the panic action. Was RBI trying to catch up following conspicuous errors in its inflation forecast, or defending the rupee ahead of the US Federal Reserve’s monetary action anticipated late that evening? While most post-policy analyses focused upon considerable upside surprises to RBI’s April inflation forecast (inflation in April 2022 turned out to be 7.8%), some drew attention to the steady depletion trend in forex reserves. So far, RBI has sold nearly $42.6 billion, i.e., 6.7% of the $640 billion reserve stock at end-October 2021, and it would appear increasingly untenable to exhaust these further in trying to defend the rupee.
It could have been both, as a weakening rupee implies a higher passthrough when international commodity prices are rising, thereby vitiating inflation outcome. But, from a policy analysis standpoint, which of the two is the dominant concern is important to know. If RBI was responding to domestic inflation, then increased data dependency would possibly provide some space to manoeuvre. But, if it was trying to defend the currency, then it would risk getting tied up with Federal Reserve’s rate cycle.
Central banks never reveal their exchange rate strategy, and RBI’s stated position is that it intervenes only to smoothen volatility. To read its mind, it is important to revisit the 2013 taper tantrum episode and the lessons learnt from that. First, there was an unexplained hesitation in imposing restrictions on gold imports that were at the core of the widening current account deficit much before the taper tantrum. Second, RBI remained ambivalent in using forex reserves to moderate the pace of rupee depreciation and thus exposed corporate balance sheets with unhedged forex exposure. And third, there was significant delay in raising interest rates and replenishing forex reserve. It was noteworthy that the Urjit Patel committee report in January 2014 (para V.24) had explicitly stated that interest rate response was found to be most effective in the 2013 episode and would be the first-round response to capital outflows in future.
The 2018 wobbles caused by rising oil prices, joined by lagging exports and continuous outflow of portfolio capital leading to raised current account deficit projections is useful to recall as well. The peak-to-trough decline in reserves ($21 billion from mid-April to July 20, 2018) or 5.8% of end-March stock of $424.5 billion matched that in April-August 2013, when the rupee had depreciated three times more (15%). While predictions of $20-22 billion NRI deposit issuance began to appear. Things weren’t any different despite a larger stock of reserves! The game is all about the magnitude of reserves spent to support the currency and the time versus keeping vulnerability indicators stable (as ratios to the stock of reserves, these deteriorate with former’s depletion!), retain market confidence and not ruffle sentiments.
In 2013, the tantrum was limited to the Federal Reserve Chairman’s expression of intent to start reversing its bond purchases. However, the actions eventually did not materialise and the dust settled within a quarter. In contrast, in 2022, central banks, particularly the world’s reserve issuer or the US Fed, have all but abandoned guidance—the only clear fact is that monetary action, belated and very small, has only just begun. Much more is to come, about which there is exceptional uncertainty within a truly disturbing geopolitical and economic context. Compared to the short-lived taper tantrum, conditions in 2022 demand real actions, which are likely to be long-drawn with real economic repercussions. If it were 2013, all would be over, say, by June? But everyone knows the inflation is not transitory but real, spreading into all corners. No one knows the trajectory of the US central bank or its economy, about China’s growth prospects, and for that matter, the efficacy of inflation targeting in settings reverse of last three decades.
Reflecting its 2013 learnings, RBI began intervening much earlier in anticipation of changes in US monetary policy, increased volatility from the Russia-Ukraine war, and its fallout upon prices and supplies. It remained calm, imparted confidence that inflation was manageable, and did not hasten monetary action in advance. However, as in 2013, the central bank delayed raising interest rate to the point that the exchange rate came into focus. This, in addition to its internal inflation assessment subsequent to April 8, likely forced an out-of-cycle hike. Both interest rates and the exchange rate are integrated, and a correction might have been forced otherwise.
What should be expected ahead? One, the situation has become delicate with the substantial fall in reserves. The RBI has spent too much, too early; it is likely left with little control, and needs to preserve firepower for the long path to normalcy towards moderating rupee adjustment. Two, interest rate action to contain inflation has only just begun and has a long distance to travel.