Opinion Letting the rupee slide isn’t the answer
A strategy of gradually arriving at an indeterminate fair value while seeking to avoid shocks might be the optimal
According to latest Reserve Bank of India (RBI) data, November saw net FDI outflow of $446 million. By Tanay Dalal
A recent editorial in The Indian Express titled ‘RBI shores up rupee. It may be good to let it be’ (December 30), suggests that the RBI should stop limiting rupee depreciation, to reach a fair value decided by trade and capital flows. I disagree. The RBI is facing an optimisation problem — how to bring the rupee to levels seen as “fair”, while minimising shocks to terms of trade and confidence, limiting any loss on corporate balance sheets, and maintaining relative health in term of foreign exchange reserves.
The idea of fair value referred to in the editorial is close to the concept of equilibrium exchange rates. It suggests long-term shifts in Real Effective Exchange rates (REER) take into account long-term shifts in both trade and capital flows — recall the steady REER appreciation of the early 2010s as global quantitative easing raised savings and the level of equilibrium capital inflows across emerging markets. The fall in global savings flagged in IMF forecasts could reduce the level of equilibrium capital inflows. This represents forces seen in the early 2010s driving REERs in reverse, but where the currency might find equilibrium is unknown. Also uncertain is the future evolution of this equilibrium value.
As seen in 2011 and 2013, a strategy of “ripping off the band-aid” could end up in a considerable overshoot in rupee depreciation. Given lower hedging volumes from the time of increased rupee predictability since 2023, this could at the margin affect now-healthy corporate balance sheets. An overshoot can also translate into higher inflation through a terms of trade shock, limiting the degree of freedom currently afforded to support growth. It is also uncertain how much a sharply weaker currency could drive a pickup in exports given current global frictions, forcing the adjustment onto the domestic economy.
A strategy of gradually arriving at an indeterminate fair value while seeking to avoid shocks might be optimal. Introduction of bouts of limited two-way volatility might also incentivise a greater amount of hedging: More limited hedging is known to exacerbate volatility as flows rush to cover positions in a procyclical way, resulting in an increased call on foreign exchange reserves to provide stability. Taken together, these operations can approximate fair value over time and minimise deleterious effects of rapid depreciation, while also building greater inherent stability.
This strategy can and will lead to a drawdown in effective FX reserve buffers — but smoothing long-term shifts while limiting damage is arguably one of the reasons these buffers exist. As per the IMF’s ARA (assessing reserve adequacy) framework, reserve requirements tend to increase with the level of control over the currency. This implies that greater freedom of movement at a later date when the currency approximates fair value would reduce the need to re-accumulate reserves — with the entire exercise representing a solution to the optimisation problem.
The writer is senior vice president, Business & Economic Research, Axis Bank
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