Over the last few months, the exchange rate has come under intense pressure, falling to nearly Rs. 80 to the dollar, its lowest level ever. Some observers have argued that this pressure can be managed easily, since the country can simply sell a portion of its foreign exchange war chest, which amounts to a healthy $580 billion. Unfortunately, currency management is not that simple. In fact, it is not obvious that dollar sales will be sufficient to resolve the exchange rate pressure – or even whether preventing depreciation is the right strategy for the economy at present.
Let’s start by considering why the rupee has been under so much pressure. A key reason is that the US Federal Reserve has begun to tighten monetary policy aggressively to control inflation, which is at a four-decade high. The Fed has already raised interest rates by 150 basis points so far this year and is expected to tighten by a further 75 basis points later this month. When the Fed raises interest rates, global investor funds shift their portfolio allocations towards US financial markets, taking the money out of other countries. In India’s case, the net sales of foreign portfolio investors have amounted to a sizeable $31 billion in 2022 so far, according to data from NSDL.
The inflow of money into the US has led to an appreciation of the dollar. The dollar index (DXY) has strengthened against its trading partners by more than 11 percent this calendar year, reaching levels last seen in 2002. The counterpart to this appreciation has been a depreciation of the pound sterling, the euro, and nearly all Emerging Market (EM) currencies. In the case of the rupee, the depreciation has amounted to a relatively modest 7 percent since January 2022.
In fact, the rupee’s depreciation has been surprisingly modest, considering that at the same time that capital has been flowing out of the country, India’s current account deficit (CAD) has also been widening. Typically, the CAD increases when aggregate demand grows so rapidly that imports rise faster than exports. However, aggregate demand in the Indian economy has been tepid since the onset of the Covid-19 pandemic and the recovery has been slow and gradual at best. So why is the CAD worsening?
Much of the answer lies in the rapid growth of import prices. India is heavily dependent on imports of petroleum (which cover 80 percent of the country’s needs) and other commodities. And supplies of commodities have been disrupted since the Russia-Ukraine war started in February 2022, causing the prices of petroleum, fertilisers, edible oils, and other products to soar. This has automatically inflated the import bill, pushing the monthly trade deficit to an all-time high of $26 billion in June 2022. On current trend, the CAD for the fiscal year could reach 3-3.5 percent of GDP.
This has put India in a difficult situation. Just when the country needs more financing to cover a widening CAD, capital has started to flow abroad. That is why the rupee has taken a tumble.
So what can be done?
Without doubt, India can utilise some of its ample foreign exchange reserves – and indeed, it has already done so. However, this is not a complete solution. When the central bank sells foreign reserves, commercial banks need to give rupees in return, draining them of liquidity. Consequently, when reserve sales become large, the liquidity drain becomes sizeable, potentially tightening the money supply far more than what is appropriate, thereby endangering economic recovery.
To address this problem, the foreign exchange intervention can be “sterilised” if the central bank buys government securities from the banks. In that case, banks will receive rupees, thereby replenishing their liquidity. But if the central bank purchases large amounts of bonds, this could push G-Sec rates down to inappropriately low levels, thereby endangering the inflation target.
For these reasons, there is a limit to the amount of foreign exchange that the central bank can sell without jeopardising its other targets. And there is a further problem: since investors know that there is a limit to the foreign exchange sales, they will be tempted to try to purchase as much as they can right now. In that way, a policy of foreign exchange sales can sometimes – paradoxically – increase the pressure on the exchange rate.
In view of the complications arising from the strategy of selling reserves, it might help to go back to fundamentals and ask a deeper question: do we really want to prevent the rupee from depreciating?
After all, if the rupee fails to follow when other EM currencies are depreciating, then India’s exports will lose competitiveness. Already, the rupee has appreciated significantly against other Asian currencies such as the South Korean won, the Thai baht and the Taiwanese dollar. If competitiveness is further eroded just when the global economic environment is turning difficult, export growth could really suffer. And that might be a big problem.
The two most important drivers of growth for an emerging economy like India are investment and exports. Private sector investment has been sluggish for several years. Last year’s recovery was highly dependent on exports, which fortunately grew exceptionally rapidly. If this engine of growth starts to sputter, so might the economic recovery.
Of course, there are costs to a weak rupee. In particular, depreciation will push up prices at a time when inflation is already a problem. But there are other mechanisms for addressing inflation, such as increases in the repo rate, which indeed are already happening. In contrast, there are no other ready mechanisms to safeguard export competitiveness, apart from the exchange rate.
In sum, reserves can indeed be used to stabilise the rupee – but only to a certain extent. And there are some important advantages to allowing the rupee to weaken, as a way of supporting India’s economic recovery process. Striking the right balance is going to be a challenge not only for India, but for all emerging economy central banks.
