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RBI’s Exchange Rate Dilemma
Context:
A recent editorial suggested that the Reserve Bank of India (RBI) should allow the Indian rupee to depreciate, stepping in only to curb excessive volatility.
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- The argument is that the rupee’s decline is part of a broader global trend, with capital outflows reflecting investors’ search for safer assets in uncertain times.
- This trend has strengthened the US dollar, influenced by both actual and anticipated policies of the Trump administration and the responses they elicit globally.
- However, the real challenge lies in understanding what allowing the rupee to depreciate truly entails, given that the pace and extent of such depreciation can become self-reinforcing.
Exchange Rate System in India
Exchange rate management in India is primarily governed by the Reserve Bank of India (RBI) under the framework established by the Foreign Exchange Management Act (FEMA) of 1999. India currently operates under a managed floating exchange rate system. This means that while the exchange rate is largely determined by market forces, the RBI intervenes periodically to stabilise or influence the currency’s value, preventing excessive volatility.
Key Features:
- Managed Float: The RBI intervenes in the foreign exchange market to smooth out fluctuations and maintain stability. This intervention can involve buying or selling foreign currency to influence the rupee’s value.
- Liberalised Exchange Rate Management System (LERMS): Implemented in the early 1990s, LERMS introduced a dual exchange rate system, allowing for partial convertibility of the Indian rupee.
- Current Account Convertibility: The Indian rupee is fully convertible on the current account, allowing for easier trade in goods and services. However, capital account transactions still face certain restrictions to manage capital flows effectively.
- Central Bank’s Role: The RBI acts as the custodian of India’s foreign exchange reserves and is responsible for managing these reserves to support the currency and intervene when necessary.
- Market Dynamics: The exchange rate reflects supply and demand dynamics in the foreign exchange market, influenced by factors such as trade balances, inflation rates, and overall economic conditions.
Self-Fulfilling Nature of Currency Expectations
- Capital Flows: One of the primary concerns is that investor expectations significantly influence capital flows.
- Value of Foreign Holdings: A rapid depreciation of the rupee erodes the value of foreign holdings in India, which, if anticipated, can trigger capital outflows.
- This, in turn, exacerbates the rupee’s decline.
- Self-Perpetuating Cycle: If the RBI signals a lack of intent to defend the currency, it could fuel such expectations, setting off a self-perpetuating cycle.
- Once capital flight begins, halting the rupee’s downward spiral becomes increasingly difficult, requiring extensive intervention that may ultimately prove ineffective.
- Investor’s Confidence: Additionally, interventions that deplete foreign exchange reserves can further weaken investor confidence in the RBI’s ability to manage currency stability.
Structural Challenges of a Market-Determined Exchange Rate
- Since the 1990s, India’s shift to a market-determined exchange rate and a more open capital account has exposed the rupee to the volatility of global financial markets.
- Unlike foreign direct investment (FDI) and commercial bank lending, volatile portfolio flows can exit a country as swiftly as they enter.
- Consequently, the rupee’s value has largely been dictated by capital movements rather than trade fundamentals.
- Despite RBI’s periodic interventions, the rupee has followed a long-term depreciation trend, barring brief periods of appreciation.
- From an annual average exchange rate of 45.56 per US dollar in 2010-11, it has steadily weakened to 82.78 in 2023-24, with a likely continuation of this trend in 2024-25.
- This pattern reflects the RBI’s inability to halt the rupee’s gradual decline, despite its interventions in the foreign exchange market.
Key Factors Driving the Rupee’s Depreciation
Two fundamental economic realities underpin the rupee’s long-term weakening.
- First: India’s inflation rate has generally been higher than that of major global economies, leading to a faster erosion of the rupee’s purchasing power compared to the US dollar.
- Since India relies heavily on imports for essential commodities like oil, currency depreciation further fuels inflation by raising import costs.
- Second: India’s structural trade imbalance persists.
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- The country’s earnings from exports of goods and services consistently fall short of its import expenditures, a gap that even substantial remittance inflows from overseas Indian workers cannot bridge.
- As a result, India remains a foreign exchange-deficit economy, relying on capital inflows to finance this gap and build foreign exchange reserves.
- While the RBI utilises these reserves to smooth out short-term currency fluctuations, the broader issue of India’s trade competitiveness remains unresolved.
- The lack of a strong manufacturing export base limits the inflow of FDI geared towards production for global markets.
While allowing gradual depreciation aligns with market forces, unchecked currency declines could trigger panic-driven capital flight. As India navigates an increasingly complex global financial landscape, managing exchange rate volatility without exhausting foreign reserves remains a formidable challenge for the central bank.
