As the rupee keeps sliding to fresh lows, there is a growing clamour for the Reserve Bank of India (RBI) to intervene far more aggressively in the foreign exchange market than it is doing at present. Those favouring such action are not entirely unjustified in their call. Since end-July, the rupee has fallen from under Rs 44 to almost Rs 55-to-the-dollar, while the RBI's forex reserves have dipped by about $27 billion. Compare this with the 2008 crisis period, when in a matter of three months from September to November, the depletion in reserves — a measure of the RBI's net dollar sales, adjusted for valuation changes — amounted to nearly $50 billion. Viewed from that standpoint, the central bank has been less active this time in selling dollars to support the rupee.
The proponents of greater intervention, however, miss out on two things. The first is that the existing forex reserves, at around $292 billion (inclusive of gold), can pay for just over seven months of India's imports. In contrast, these sufficed for 13 months at the time when Lehman Brothers went belly-up. The crisis then, in a sense, presented an opportunity for the RBI to shed what many then considered as excess reserves in its kitty. Today, though, nobody can really compare the RBI's plight on currency reserves with that of the Food Corporation of India on grain stocks: There isn't a whole lot of dollars with the former to play around with. The second point is about the effectiveness of intervention itself. In 2008-09, the RBI, even after selling so heavily, couldn't halt the rupee's decline from below Rs 44 to Rs 52 by early-March. When fundamental factors are at work — a sudden drying-up of capital inflows (as in 2008) or unsustainable current account deficits (as is the case now) — there is only so much that intervention can do.
What is the purpose of holding reserves, then? Well, certainly not to fight fundamentals. Reserves are meant only to prevent excessive exchange rate volatility, or moves at ‘shorting' the rupee through speculative trades. The RBI has been reasonably successful in this regard. It has also done the right thing in allowing the rupee to depreciate to levels that would force companies to re-examine the import intensity of their operations. Any artificial attempts at propping up the currency would only delay these adjustments, which are necessary to reduce the current account deficit (CAD) to below $50 billion — against the $ 75 billion for 2011-12. The Government, too, should cooperate, by rationalising domestic prices of petro-products and fertilisers, so as to align their demand with balance of payments considerations. All this would eventually help keep the CAD at levels that can be sustainably funded by normal capital inflows. And that, not RBI intervention, is the ultimate solution for the rupee as well.