Political indices of a depreciated rupee

India’s exchange rate regime underwent a big change in the early 1990s. From the Reserve Bank of India (RBI) determining the exchange rate every day, we first moved to a dual exchange rate regime and a year later, in 1993, we adopted a market-determined exchange rate regime. It was clarified that RBI would step in if necessary. The openness of the external sector, which included a liberal trade policy, a market-determined exchange rate and expanded sources of external capital flows, significantly strengthened the external sector.

The exchange rate system has changed the whole world. After the abandonment of the fixed exchange rate system adopted by the International Monetary Fund (IMF), there was much confusion, leading to a series of conferences and consultations. Finally, developed countries have moved to a market-determined exchange rate system; they care much less about rate fluctuations. Among them, an attitude of “benign negligence” now prevails.

How has India handled the new regime since 1993? : Overall, the management of the external sector is a success of the reform process. The current account deficit remained low at less than 2% of gross domestic product (GDP) from 1992-93 to 2008-09. There were two years when there was a surplus. Between 2008-09 and 2012-13 it remained above 2% of GDP and in 2011-12 and 2012-13 it exceeded 4%. But financing the current account deficit has not been a problem due to ample capital account inflows. The exception was 2012-2013, when funding became an issue. Since then, the current account deficit has been modest, except for the current year when it can reach 3% of GDP.

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In the absence of capital flows, the exchange rate is largely determined by the current account of the balance of payments (BoP). Exports earn foreign exchange and contribute to the foreign exchange supply. Imports involve the payment of foreign currency and constitute a demand for it. But the picture changes with the inclusion of capital flows. Capital inflows add to the foreign exchange supply and a large inflow can cause the domestic currency to strengthen despite a current account deficit. The theory of purchasing power parity, according to which the external value of money reflects its internal value, only holds when capital flows are minimal. Foreign investment (ie inflows) in India has been quite significant since 1994-95. Most years it has been above 1.5% of GDP. In several years like 2009-10 and 2014-15, it had exceeded 3% of GDP. These capital inflows, when they exceed the current account deficit, help the RBI build up reserves if it does not allow the value of the rupee to appreciate beyond a certain level. This is how our reserves were built up to the current level, which exceeds 600 billion dollars. This is a far cry from the way China has built up reserves. China has mainly built up its reserves from its current account surplus. This makes a difference on the quality of the reserves. Among the various elements that have helped India to accumulate reserves, some are volatile. The most important of these is foreign portfolio investment. Investing in the stock market can flow easily if perceptions change. Non-resident Indian deposits are generally considered durable. But we witnessed with horror their volatility in 1990 and 1991. Let us take two examples: the “taper tantrum” of 2013 and the current situation after the Russian-Ukrainian war. During the “taper tantrum” period, there was a sudden withdrawal of funds through the sale of stocks, which led to a sharp drop in the value of the rupee. In May 2013, the value of the US dollar was equal to 55.01. In September 2013, it had moved to 63.75. But as sentiment turned around and also as a result of some measures taken, capital inflows picked up and the value of the dollar in terms of rupees fell. But it remained above its May level even after a year. Something similar can happen in the current situation. The value of the rupee, which has fallen sharply, could recover when capital inflows resume. But this will not necessarily reach the pre-crisis level.

What are the lessons of these experiences? : A shock to the value of the rupee can occur whenever there are sudden pullbacks. Just as the influx of funds helps to increase the value of the rupee, the withdrawal of funds can cause the value of the rupee to fall. Volatile elements must be monitored. When the sentiment changes, these volatile elements give a shock. We need to accept this fact, and while taking steps to reverse sentiment, we need to recognize the nature of the market.

However, we need to focus on two related issues: first, the size of the current account deficit and second, the behavior of domestic prices. India’s problem until the late 1980s was how to finance the current account deficit. That may not be a problem now. But that does not allow us not to worry about the level of the current account deficit. Inflows in the form of loans impose a burden of interest payments. As inflows increase to meet or exceed the current account deficit, the volatile elements of reserves also increase, causing a shock from time to time. It is better to keep the current account deficit around 1.5% of GDP, a level close to sustainable inflows. The days of a current account surplus at this point seem distant. Second, despite strong capital inflows, the rupee depreciated. In June 1993, the value of the dollar was equal to 31.3. Today it is equal to 80. Please remember there was a time when it was equal to 4.75. This is where the theory of purchasing power parity has some relevance. In the final analysis, inflation differentials between countries matter. Export competitiveness is correlated with low inflation. Our own inflation targets cannot be too far from the targets of other countries, if we are to contain the depreciation of the rupee.

C. Rangarajan is former Chairman of the Prime Minister’s Economic Advisory Council and former Governor of the Reserve Bank of India.

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