RBI’s endgame for rupee must be a win for credibility

The rupee continued its fall to touch a fresh record low on September 28. This is not the first episode of depreciation for the unit although exchange rate management has become more complicated for the Reserve Bank of India (RBI). India’s central bank had an easier task during the East Asian crisis that roiled currencies in 1997.

The RBI has since evolved into a more hands-on central bank when it comes to the partially floating rupee. But at the heart of every crisis that the RBI has dealt with when it comes to the impact on the exchange rate, credibility has been a key factor.

Market interventions during 2008 and 2013 showed that the central bank cannot afford to lose credibility when the economy is under pressure through external factors. How can the RBI hold on to its credibility this time? There are no easy answers to this question and the market is divided on the approach the central bank should take. On its part, the RBI needs to strike a balance in ensuring that both exchange rate and interest rates are conducive to macro stability.

The hands-on sentinel

This is the role the RBI has taken on over the past several months, supporting the rupee during intense bouts of depreciation or taming it during a surge period. The motivation is to let the exchange rate adequately reflect macro stability indicators. A strong currency is often seen as a reflection of global investors’ faith in that economy. For a capital-starved country like India, this is critical. HDFC Bank chief economist Abheek Barua argues that even now the RBI must not give up on its defence. “The central bank should intervene to ensure that a falling currency does not eclipse India’s fundamentals,” he said in a recent note. Barua’s argument is sound given that India is still seen as a destination offering growth and high yield.

Foreign investors continue to have a favourable view of our markets. Foreign direct investment inflows have held up and portfolio flows too have turned positive in recent weeks. In short, the RBI’s intervention has been seen positively by the markets and also helped keep credibility intact. Interestingly, though, as its powers to intervene in the forex market continue to reduce, the RBI is faced with a key challenge to credibility.

Constant involvement in the forex market gives an incentive for foreign investors to vacate the market too as the central bank is seen as a ready buyer of dollars. This leaves domestic investors feeling short-changed. Questions of whether it can safeguard the economy from the headwinds of external shocks have emerged as its firepower to intervene reduces.

Finding dollars for the kitty

As forex reserves plummet, their adequacy indicators have taken a hit. In 2013, the RBI had a tough time maintaining its standing when it used a combination of various instruments to prop up the rupee. Some of the measures were seen as born out of desperation. Despite the efforts, it ended up losing control of the exchange rate in which period the rupee plummeted to a record low and domestic bond yields surged. A low reserves pile and weak external indicators made it difficult for the central bank to offer support in the forex market. It took an out-of-the-box set of measures on September 24, 2013, to restore the lost credibility as reserves were beefed up. Fast-forward to today, the challenge to find dollars for the kitty is back and the RBI can take a relook at its 2013 playbook wherein it incentivised banks to lure dollars through non-resident Indians. Another way to attract dollars is to hike policy rates, giving the US Federal Reserve enough competition and putting a stop to the narrowing interest rate differential between India and US. However, this is rife with pitfalls as observed earlier.

An economist puts it better. “Interest rates are a blunt instrument. It is better not to use them for exchange rate purposes and rather deal with the second and third order impact of a falling rupee on the economy through other measures,” he said, requesting anonymity.

Time to let go

This brings us to the growing view that the RBI must let the rupee find its value through market forces. In other words, the central bank needs to ease off. The view stems from the fact that India is losing its firepower to keep up its defence against the dollar as reserves have plummeted by more than $90 billion in just a year. Adequacy indicators of the forex pile have been hit even as there are no signs that external headwinds will pass. Reserves can only cover nine months of imports now. This explains why economists from Standard Chartered Bank and Barclays believe that the RBI must take its foot off the intervention pedal. “While we do not see any weakness in reserve adequacy, to ensure macro stability we believe it will be imperative to keep a close eye on the external balance sheet. India’s policymakers will likely have to allow for relative prices, including the exchange rate, to adjust given the thinning buffers,” Barclays economists wrote in a September 22 note.

Regardless of the approach the RBI takes, tactical tweaks in market intervention is necessary. Exchange rate policy has incidental outcomes on the RBI’s interest rate policy. Managing these outcomes will help the central bank maintain its credibility more than using either one to influence the other.