Should RBI prevent further rupee appreciation?

There is a lot of chatter in money market circles that RBI should not allow a runaway appreciation of the rupee.

As of now the rupee has appreciated 12.5 percent from its all time low scaled on Aug 28 and again on September 4. However,  the rupee is still 11 percent cheaper year-to-date and 15 percent cheaper than year ago levels.

Rupee’s impact on the country’s trade deficit has been salutary. From the average trade deficit of USD 20 billion per month seen in the months of November and December last year, the trade deficit has dropped to less than USD 10 billion in September. The current account deficit too has fallen from 5.7 percent in the Oct –Dec quarter last year, to probably near zero in Q2 this year and possibly 2.5-3 percent for FY14 as a whole. 

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Therefore, there could be a case for the RBI to workout a fair range for the rupee around 58-62 per dollar and keep it there since it has resolved the big problem of a rising current account deficit along with other factors.

The need to guard against appreciation also stems from the fact that domestic inflation continues unabated, reducing domestic competitiveness. Also a reversal of capital flows cannot be ruled out since the US fed could well start tapering in the first quarter of 2014. So, although that may not unnerve emerging market currencies as much as it did in May and June this year, some outflow should be expected. Hence some build up of reserves may not be bad.

Attendant risks to be noted

For one, rupee appreciation is still some distance away - On Friday, merely on reports that the RBI may close its swap facility and allow oil companies to buy dollars from the market, sent the dollar rising by 75 paise in just 15 minutes. The rupee is still where it is only because of policy props.

The RBI has to bring the marginal standing facility (MSF) rate down to 100 bps over repo. It needs to dismantle the limits placed on repo borrowing, so that the call rate is aligned with the repo rate. Then it has to slowly bring in the oil demand into the market. Only then can we consider whether the rupee has stabilised.

Even then, it won’t be easy for RBI to start buying dollars to prevent rupee appreciation all that easily. Any such purchase can lead to an over reaction in the market leading to a sharp rupee fall and a vicious chain reaction.

The RBI will have to disguise its action as one intended to soften volatility than target a level. A sharp depreciation can also have consequences for inflation.

Therefore, it is still too facile and too early to dream that the day is near when RBI can absorb surplus dollars and build reserves.