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Step back into the ring

On the rupee, the RBI needs to rethink its arm’s length policy

Less than two months back, a semblance of macroeconomic stability had finally returned to India. Inflation was moderating, IP numbers were looking up, the fiscal consolidation was even more impressive than had been expected, and the only debate was how much space the RBI had to ease monetary policy. The rupee shock since then has dramatically changed that conversation. The inexorable weakening of the rupee has sparked fears of inflation reigniting, the subsidy bill blowing up, and corporate balance sheets getting seriously stressed.

On the face of it, nothing has fundamentally changed in India in the last two months. Only the world has become riskier after the US Fed announced slowing its quantitative easing (QE) earlier than anticipated. With renewed global risk aversion, capital flows to all emerging market (EM) economies with a current account deficit dried up, sending their currencies into a tailspin. Taking comfort in not being singled out and blaming the rupee’s woes to unfortunate collateral damage from the global shock, India’s policymakers have so far done precious little to stop the rupee bleeding. Sebi’s tightening of trading norms in the currency derivatives markets is too modest and too late to have any meaningful impact other than reducing market liquidity even further. For now, the reduction in market liquidity might make any foreign exchange intervention by the RBI more effective, but when the next shock hits India, rupee volatility will spike that much more.

To be sure, the RBI has kept the rupee at arm’s length for quite a while. And this is the right thing to do. The rupee should reflect not just trade and capital flows but also our fears and faith in the economy and policies. And it is here that things become complicated. It is one thing to not stand in the way of the exchange rate fully pricing fundamentals, but when the very choice of policy inaction itself becomes the driver of rupee dynamics, then a central bank needs to step back into the ring, and that too with force.

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