Monetary tightening may not be the most effective way or a durable solution to deal with the weakening currency, but is often practiced by countries facing a run on their currencies. Its appropriateness needs to be evaluated in the context in which it is resorted to.

Containing currency volatility has been a major challenge for the Reserve Bank of India (RBI) since the Lehman crisis, and particularly this year. India’s current account deficit has risen sharply to unsustainable levels over the last few years. With external vulnerability on the rise, even small external shocks are causing massive volatility in the rupee. The rupee has depreciated by 12 per cent since March this year.

If the RBI had not intervened, the rupee’s continued fall could have caused widespread panic and led to convulsions in other areas, such as capital markets and among corporates; the risk to the economy would have been far greater. So, the tightening measures announced by the RBI on July 15 were appropriate. They will complement some other steps taken by the central bank and the government to encourage capital flows, such as relaxing the limits for foreign participation in bond markets and reducing withholding tax. In addition, Indian authorities have taken steps aimed at curbing speculative trading in currency markets.

RBI’s recent action cannot be categorised as conventional monetary tightening as it did not touch either the repo rate or the cash reserve ratio (CRR). The transmission was instantaneous and bond yields firmed up when trade opened the next day and the rupee strengthened.

So far so good.

These measures have helped strengthen the rupee, but will raise the cost of borrowings for banks. The adverse impact on growth will depend on how long they remain in place. If these measures persist, they will hurt India’s growth prospects. Even if these are pulled back, it now seems unlikely that the lending rates can come down and support growth. Due to heightened concerns on currency and the upside risk to inflation, RBI may not cut rates through the rest of this fiscal.

The steps taken so far to check currency volatility are short term in nature. In the long run, however, it is important to bring the current account deficit down to sustainable levels to reduce the risk of excessive swings in currency.

Lowering the fiscal deficit and also the import bill through decisive reduction of subsidies, focusing on improving export competitiveness, and tapping newer, fast-growth markets will be key measures toward this goal. Unless that happens, we will be at the mercy of global risk appetite and liquidity and will have to resort to short-term fixes.

(The author is Chief Economist, Crisil. The views are personal.)

Read also: Is tight money the best way to deal with falling Re? - No

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