To what extent can policy challenges and economic circumstances change over four years? Well, sometimes, they can turn upside down. Around this time in , the Reserve Bank of India RBI was struggling to save the rupee from a free fall and was forced to raise emergency foreign currency deposits from non-resident Indians. The concerns today are an appreciating currency, and the problems the central bank is facing in managing the strong rupee.
The problem now is of plenty. Curiously, a recent report by Edelweiss Securities Ltd noted that sustained intervention by the RBI has brought India close to getting included in the currency manipulation watch list of the US. Even though India has a trade surplus with the US, and has been intervening in the currency market, it still runs a current account deficit at the aggregate level and cannot be accused of currency manipulation.
Thanks to excessively accommodative monetary policy in the developed world, the global financial system is flush with cheap money and investors are in a desperate search for yield. Here is an example. While strong foreign flows and rising reserves would be comforting for policymakers on the one hand, they pose significant policy challenges on the other.
The currency export and trade-based real effective exchange rate index in July was at It is sometimes argued that India should not worry about currency, especially with an inflation-targeting regime in place, and export competitiveness is not solely dependent on the exchange rate.
It is correct that external competitiveness is not exclusively dependent on the exchange rate, but it is also true that markets sometimes tend to overshoot in the short to medium term. Therefore, there is no harm in quelling volatility if possible, and giving businesses a more stable economic environment.
There have been at least two instances in recent history that support the idea of intervention when necessary. First, on the back of strong inflows, the RBI accumulated reserves at an accelerated pace between and early , which helped India deal with the consequences of the global financial crisis.
Second, inadequate intervention in the years preceding the taper tantrum episode resulted in a higher current account deficit and India got pushed dangerously close to a crisis. To be sure, intervention in the currency market has costs and central banks do not have unlimited power to influence outcomes. Further, the present liquidity situation is making things more difficult for the RBI. The banking system has excess liquidity of around Rs3 trillion and currency market intervention will increase this.
Even though there is no imminent threat of high inflation, persistent surplus liquidity can affect monetary policy operations. For example, liquidity management costs after demonetization could be one of the reasons why the RBI gave a lower-than-expected dividend to the government.
Also, yields on foreign assets are much lower than government of India bonds—and sterilized intervention is in effect a switch in central bank holdings from rupee to dollar securities. So how can the central bank deal with this problem of plenty? One option is to work with the government and use an instrument like market stabilization scheme bonds and continue to build reserves.
But, in this case, the cost would keep rising as higher reserves would attract more flows. Rising reserves will reduce the currency risk for foreign investors. The other option is that now that India has adequate reserves and stable macros, it reassesses the kind of foreign funds it wants.
For instance, flows in the form of equity capital are more stable and less risky compared with debt. Policy rationalization on this front can ease the pressure on both the RBI and the rupee. Now that India has adequate forex reserves and stable macros, it can reassess the kind of foreign funds it wants. Tue, Aug 29 India forex reserves RBI foreign exchange rupee.
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