C Rangarajan weighs in on the factors that are driving the depreciation of the rupee, and why it is essential to contain domestic inflation to stop the slide.
First of all, we need to understand how the value of the rupee is determined. Several decades ago, there was a theory called the purchasing power parity theory, which explained how the value of any currency is determined. The idea was that the external value of a currency is determined by its internal value — meaning that the rate differential between one currency and another depends upon the difference in the inflation in the two countries. That was a time when the balance of payments of a country was dominated by what we call the current account — that is, the export and import of goods and services.
But over time, this has changed. An important element now is the capital account in the balance of payments — which means the inflow and outflow of funds. The value of a currency can be strong despite the fact that it has a high current account deficit because there is enough capital flowing from outside into the country. Therefore, the supply of foreign currency increases not because of [trade] but because of the decision to invest or because of the decision to keep deposits in our country.
In some sense what has happened in the Indian situation — and this is true of many other countries as well — is that the main reason for the rupee depreciating in its value, let’s say against the dollar, is because the funds inflow into our country started diminishing. That is because the Fed, with a view to control inflation in the United States, really raised the rate of interest.
Therefore, investors find the United States is [more] attractive, because of the higher rate of interest. Instead of sending funds outside, they are keeping the funds inside and sometimes, as it has happened in the present case, they withdrew the funds from India and put them in the United States.
Therefore, the reason why there is a sudden decline in the value of the rupee is because of the capital account, because of the outflow of funds and the lack of funds coming from outside.
There are various forms through which funds flow, but generally speaking, when the investment becomes more attractive domestically, foreign countries do not send funds into other countries, and this is precisely what has happened, because the fluctuation in the value of the rupee was quite sudden.
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In a sense, an undervalued currency is better because it is more attractive for exports. But at the same time, we have to understand that this (depreciation against the dollar) cannot go on; this cannot be a continuous process. Please remember, immediately after the IMF was formed, the dollar was equal to 4.75 rupees and today we are talking in terms of 80 rupees to the dollar or a little more.
So, I would say that at a particular point in time, the devaluation or the depreciation in the value of the domestic currency may be advantageous because we have a tough balance of payments situation and we need to export more and reduce the current account deficit.
But this cannot go on continuously…because ultimately what we are essentially saying is that for getting $1 the amount of the resources that you need in India is becoming higher and higher. Therefore, the steady deterioration in the value of the rupee is not something that one would advocate.
And this is where the whole purchasing power parity comes [into the picture]. So long as inflation in our country is higher than the inflation in other countries, the value of the rupee will (continue to) depreciate.
I have always taken the position that we must reduce our inflation rate.
For example, the US talks of 2% as the appropriate inflation, whereas, we talk of 4% as the appropriate inflation, even though our actual inflation may be higher, but at least the goal is 4%. If you have this (setting), then every year the value of the rupee will have to depreciate.
The point is that the current situation has been aggravated because of the capital flows. But over a period of time, we really need to see that our inflation — while it may not necessarily be equal to their inflation — (is) at least close to it and the margin is not that high.
From the Monetary Policy Committee minutes and statements, there appears to be an increasing divergence between what the RBI needs to do to control inflation domestically and what it might have to do to support the rupee against the interest rate hikes in the US. What should the RBI do?
A conflict of that kind does not actually exist.
I will say that even in India inflation is at a higher level. We had set 6% as the upper limit in the inflation targeting scheme, but the inflation rate has been above 6% for almost nine months.
Therefore, we too need to control inflation. In some senses, raising the rate of interest is serving two purposes: it moderates inflation and at the same time, it does have an effect in terms of the value of the rupee as well.
Therefore, I don’t see that (conflict) at the moment, but the question that will arise: to what extent (should the RBI raise the interest rates)?
I do not think that India can say that we will not raise the rate of interest. I think that is ruled out in my opinion… (Because) I think we really have a problem, we also have a high inflation, (and) we need to bring it down.
Dr Rangarajan was RBI Governor between 1992 and 1997 as India embraced economic reforms. His new book, Forks in the Road: My Days at RBI and Beyond, was published this month. This is an edited excerpt of his interview to Udit Misra.