RBI’s Exchange Rate Choices

(The following article appeared in moneycontrol.com on 21Jun2022:

https://www.moneycontrol.com/news/opinion/rbi-can-afford-to-let-rupee-depreciate-a-bit-8714721.html )

RBI’s Exchange Rate Choices

For long now, RBI has used a banal statement to describe its foreign exchange management policy – ‘we do not target any specific level for the Rupee; we only intervene to control excessive volatility’.

 

Reality, however, is complicated. RBI often finds that it must make involved choices, and sometimes intervene in exchange markets to an extent that it practically sets market prices. 

 

As an example, take the pandemic impacted fiscal year 2020-21 (FY21). India saw a flood of foreign currency inflows in that year. With domestic consumption and imports contracting sharply, India’s current account balance (the sum of India’s net goods and services trade and remittances) swung from a deficit of USD 25 bn in FY20 to a surplus of USD 24 bn in FY21. Add USD 44 bn of net Foreign Direct Investments (FDI), and USD 39 bn of Foreign Portfolio Investor (FPI) equity inflows, and the FY21 core balance across the three was a net inflow of USD 107 bn – an all-time high. 

 

Amidst this deluge, had the RBI stayed away from currency markets, USDINR could have dropped steeply from the pre-pandemic level of 72.50. Instead, RBI consciously intervened and mopped up a record USD 147 bn across spot and forward markets through FY21, and USDINR never fell below 72.00.

 

Several considerations likely went into RBI’s FY21 intervention strategy. For one, RBI likely surmised – correctly – that this flood of foreign currency inflows was an aberration born out of the pandemic. If they had ‘let the market find its level’, we would have seen USDINR drop precipitously, only to revert when more normal current account deficits resumed. The intervening volatility would have hurt anyone with a foreign exchange exposure, including those considering investments into India. Second, a sharp strengthening of INR would have hurt exports, and cheaper imports would have threatened domestic manufacturers. With domestic industry already reeling under the pandemic, an added exchange rate handicap could have been debilitating. Hindsight confirms that the RBI was right to do what it did.

 

The situation has changed dramatically since then. 

 

We are now seeing the prospects of large foreign exchange outflows in the current fiscal year. Given trends in prices of crude oil, coal, edible oil, fertilizers, chemicals, and other commodities, and amidst extended global supply chain disruptions, our FY23 Current Account Deficit (CAD) could exceed USD 100 bn. While FY23 net FDI could end at USD 40-45 bn, so far, FPI outflows have already exceeded USD 11 bn. Overall, we could be looking at a core FY23 outflow of possibly USD 60-70 bn. In addition, if fears of rapid INR depreciation were to gather steam, there could be an additional rush by importers and foreign currency borrowers to hedge their foreign exchange exposures.

 

In addition, amidst persistent geopolitical tensions and rapid monetary policy normalization by the US Federal Reserve, the USD itself has strengthened on average by about 14% this year against major currencies such as EUR, GBP, and JPY.

 

How should RBI now approach our currency markets?

 

Across reserves and outstanding forward purchases, as of April 2022, RBI held ample exchange buffers of USD 662 bn; over 21% of GDP. Just as it intervened during FY21 to absorb huge inflows of foreign exchange, should it now draw down on its buffers to arrest the fall in Rupee? 

 

There are two scenarios that we could consider from here – the base case, and the stress case. 

 

As of the writing of this report, commodity futures markets suggest that amidst an impending global economic slowdown, Brent crude oil prices will come off from an average of USD 105 per barrel in 2022 to USD 81 per barrel in 2025. India’s CAD should then improve from over USD 100 bn in FY23 to perhaps less than USD 50 bn in FY25. This does make a case for RBI to use its current buffers to douse the interim currency market volatility.

 

It isn’t that simple, however. At USDINR of 78.00 now, INR has weakened by about 5% against USD over the past year. However, given overall USD strength, INR has strengthened by 7% against EUR, and by 14% against JPY. RBI’s preferred metric to measure Rupee’s relative competitive strength – the 40-country Real Effective Exchange Rate – indicates that as of May 2022, INR was about 5% overvalued. Given that our external balance is dominated by consumption-oriented imports (of energy, gold, electronics, machinery, chemicals, plastics etc.) funded by somewhat fickle capital inflows, large currency overvaluation is not desirable for domestic job and output creation. 

 

Beyond this, what happens if crude oil prices were to average USD 105 per barrel or more for the next three years? This is not unthinkable – during the six years between FY09 and FY14, brent crude oil averaged USD 102 per barrel. 

 

If history was to partly repeat, unless our real economy responds strongly in the interim with enhanced exports and reduced imports, RBI currency buffers could well fall again to 15% of GDP in three years’ time – a recipe for external instability. One way to prepare for this stress scenario would again be to allow INR to gently weaken over time, so that our CAD could have space to improve. 

 

In summary, while RBI does have ample foreign exchange buffers for now, a gentle depreciation of the Rupee may well be called for – both to correct INR overvaluation, and to prepare for possible stress scenarios. We then must use the time made available by the RBI’s buffers to create domestic jobs and output, so that our external balance improves. This could well mean USDINR should cross 80.00 before long, even if it makes for unpleasant newspaper headlines. All of this will have implications for capital flows, inflation, and monetary policy – even if our current policy framework does not give adequate attention to these linkages. 

Finally, perhaps it is time that we considered putting together a comprehensive and formal currency management policy framework, consistent with our monetary policy framework, that replaces the black box approach that we follow today.