The rupee has breached the upper bound of its float against the dollar, having depreciated by around 19 per cent against the greenback since mid-August. India has a high current account deficit. In normal times, this deficit is financed through debt and non-debt-creating capital flows. Both debt and non-debt-creating flows have fallen short by around US $10 billion during April-August of 2011-12, compared with April-August 2010-11.
Notwithstanding strong FDI inflows, the drop in portfolio inflows and the rise in current account and fiscal deficits have led the rupee's recent decline. FIIs have sold a net US $85 million worth of equities so far in 2011. This is in sharp contrast to the $29 billion they invested in 2010. In November alone, foreign funds have pulled out US $858 million from the equity market. The drying of capital flows, especially those from FIIs in 2011, are partly due to extraneous reasons, beyond the control of Indian policymakers.
However, part of the reason for FII disinterest in the India story in 2011-12 is the government's poor economic management. A restrictive monetary policy should have encouraged portfolio flows, as the interest rate differential between India and the FII-originating nations has increased. Thin FII flows despite widening interest rate differential are a reflection of poor progress in resolving governance and infrastructure bottlenecks.
RBI could have prevented the depreciation through active intervention in the forex market, selling dollars from its kitty. By not intervening, RBI has refused to accommodate the fall in rupee, arising from the government's inaction.
We have seen a gradual erosion of credibility of the government in its commitment to unleash reforms. The shelving of FDI in multi-brand retail is a case in point.
CONSISTENCY OF ACTION
The central bank has not fallen prey to the problem of time inconsistency — pursuing a course of action opposite to its avowed policy stance. Therefore, it has not intervened actively to prevent the slide of the rupee. Active intervention in the currency market would have contradicted its stated policy stance of non-intervention. This stance has reinforced the credibility of RBI as a central bank.
There are more mundane and practical aspects relating to adequacy of forex, if the RBI were to intervene in a big way. India has forex reserves of US $306 billion. However, India's external debt now equals its forex reserves. Recently, the debt components of capital inflows have risen significantly and FII flows have been fickle.
If there is a large capital outflow , the adequacy of reserves will have to be judged not only by its ability to finance the current account deficit but also to meet short-term claims without a loss of confidence in the economy. RBI would have less firepower, in the event of a repeat of the run on the currency seen in the third week of November.
There is a view that as the domestic economy slows down, the demand for imports would slow down. The slowdown-induced improvement in the current account deficit (CAD) will act as a built-in stabiliser against rupee depreciation. However, given the inelastic nature of some of our major items of import, one is sceptical about a slowdown resulting in a significant improvement in CAD. A case in point is the demand for petroleum products.
RIGHT POSTURING
Could the RBI have charted a different course to prevent the large slide of the rupee, without being time-inconsistent?
Theory posits that if capital flows dry out, in a fully flexible exchange rate system, the rupee should depreciate significantly so as to bring the current account in balance by compressing imports and encouraging exports. However, in practice, speculation by currency traders can take the rupee depreciation to a level not warranted by the dynamics of the current account.
Right posturing and timely intervention on part of RBI in the forex market could have dampened speculation on the rupee. Perhaps, the extent of intervention need not have been too large if it were timed well. Moreover, to the extent pure speculation drives volatility, RBI has a moral responsibility to intervene and prevent the mean from shifting. Very recently, RBI rose to the occasion when speculation drove rupee to its lowest on December 15 in intraday trade. Apart from intervening, RBI introduced measures to curb speculation in the forex market by reducing the open dollar position for banks and also the extent of cancellation and rebooking of the forward contract by exporters and importers. These measures had a telling impact as the rupee value increased by close to 100 paise on the next day.
RBI has responded when pushed to the wall. Perhaps, next time around RBI will be more proactive in managing currency expectations.
(The author is Associate Professor, Xavier Institute of Management, Bhubaneswar. The views are personal.)