The rupee must be free to find its own level and reflect economic fundamentals
High volatility of the rupee,such as that seen this week,is something we have to learn to live with. As the size of Indias trade with the world grows,as Indias financial integration with the world increases,the flows on the foreign exchange market are getting larger all the time. Inflows and outflows on the trade and financial markets will impact the exchange rate of the rupee. Since March 2007,the RBI has mostly allowed the rupee to find its own level. This is a sensible policy. If the RBI were to try to intervene,and the world knows that it had a target in mind,it could lose a few billion dollars in a day. A defence of the rupee could only lead to a loss of reserves and a loss of face.
Where should we expect the rupee to go? In the short term,there are often no good explanations for why asset prices move up or down. Most research that tries to explain short-term movements of exchange rates has very poor performance. The alternative is to look at fundamentals that do not often explain short-term movements,but in the long run,may broadly explain the direction of movement of a currency. In the case of the INR/USD rate,Indian inflation is higher than the inflation in the developed world and in most other countries today. This inflation differential,in the long run,would push the rupee to depreciate. This is good for Indian exports,otherwise,they would become less attractive than exports from other countries that have lower inflation rates.
What should be done to curb the rupee fall? The best answer is,nothing. If this is an opportunity to ease capital controls,as the government seems to be doing on many fronts,that opportunity should be taken not merely to ease them,but to rationalise them and clean up the mess we have. Today,the mood of the government is to prevent any depreciation,as it would further increase the price of tradables and push up inflation. This should not translate into pressure on the RBI to intervene. The exchange rate is the most important price in the economy and any attempt at manipulating it will not work for long. We have to learn to live with a volatile rupee that will find its own level and reflect the fundamentals of the economy. As the Indian economy grows bigger,the best policy for us is to have a fully flexible exchange rate where we do not worry about the daily movements of the rate.