The rupee in the age of free fall

The central bank watched benignly while the rupee fell from 36.20 on October 21 to 36.60 on November 10. Neither did it spring into action when on November 21 the exchange rate fell to 37.75 and only entered the picture to sell dollars three days later when it dipped past the “psychological” number of 38.

Thus the RBI indicated by its actions — or inactions — its intentions not to react to every slight quiver of the exchange rate. Its policy now is to only come in when severe volatility in exchange rate markets threatens to disrupt the rest of the system.

More importantly, it bore out the widespread feeling that the government is not averse to allowing the rupee to slide to 40 in the near future. The rupee has generally been held to be overvalued. Also, the recent depreciation in the currencies of many of our Asian export competitors now means that Indian exports, which have not been performing well in recent months, would take a further beating.

But the rupee has only fallen around 7.5 per cent in the last six months, against depreciations of 36 per cent in the Thai baht and 24 per cent in the Philippine peso. The rupee, it seems, should be allowed to fall gradually to around 40 in the next few weeks.

The problem with this approach is that even the best of nannies can’t always foresee a crisis or predict precisely when they should intervene. Also, there is no telling whether, when the RBI jams the brakes on, the exchange rate will screech to a halt at around the targeted line, or overshoot it grossly, thus only aggravating the situation.

Until now the RBI has been able to operate the managed float of the rupee very well, thanks to the still-remaining elements of command and control in this segment of the economy. For example, a nod from the RBI to big dollar guzzlers, such as Indian Oil, can prevent it from withdrawing dollars from the Indian market, which would add to the escalating rate; dollars for imports can be supplied to IOC by the State Bank of India abroad.

It is not as though the floodgates will be opened and the economy will be swept away. But in changing times, policies also need to “float” if they are to be effective. For a start, the vagaries of globalisation have to be factored in. Because, apart from the tottering political situation in the country, analysts blame the domino effect from the East for the rupee’s recent fall.

The thinness of the foreign exchange market has been quoted as a restraining factor, but it works both ways; it allows the RBI to sterilise dollar outflows cheaply, but it also allows speculators to jump in and manipulate the exchange rate.

At what cost will it sterilise the rupee in the future? In the recent fall, the RBI found it necessary to sell an estimated $ 500 million to try to fit the rupee into the right exchange-rate peg. Foreign exchange reserves of around $ 30 billion seem paltry when compared to Taiwan’s $ 90 billion, which did little to prevent the Taiwan dollar’s downward spiral. Also, India’s foreign currency assets have been declining.

The managed float can still work, but at what price? At what cost will the RBI stick to the recently announced five per cent fluctuation around 38.40? How frequently will this peg be updated, given the frequent changes in other macro variables? And surely the announcement of such a peg will only give rise to larger degrees of speculation, and more of an imbalance.

It would be more efficient to let the rupee fall to a market-determined rate of exchange. Speculation will soon run its course, especially when the players realise that the Central Bank is not committed to maintaining the currency at any pre-determined level.

The writer is a consultant with Indian Public Affairs Network