India should allow the rupee to depreciate and focus on controlling inflation
Illustration: Shyamal Banerjee/Mint
Financial markets do not follow the neat patterns of the calendar. Yet, the turbulent events of the first week of May bring back memories of how traders broke into a cold sweat in the midst of a hot summer almost exactly two years ago.
The US Federal Reserve had first indicated in May 2013 that it would soon begin to withdraw its extraordinary monetary stimulus, also known as quantitative easing. India had to face an avalanche of selling that hit the most fragile emerging market economies. Quantitative easing has ended. The discussion right now is about when the US will begin to increase interest rates. The Indian financial markets have already been rattled. The BSE Sensex has fallen to its lowest level in six months. The Indian rupee touched its lowest level against the dollar in 20 months.
There are undoubtedly several domestic factors that have also cast a long shadow of doubt over the financial markets. The insipid quarterly results are one example. But it is also true that global factors are at play. Indian equity prices have traditionally been negatively correlated with US bond yields—and these have begun to climb.
How well is India placed to deal with a new round of global turbulence? It is well known that India is now better placed than it was two years ago in terms of the three standard measures of economic stability: inflation, the fiscal deficit and the current account gap. Indian policymakers across two governments deserve credit for learning the right lessons from the manic weeks of 2013.
Take a look at some numbers. The Reserve Bank of India (RBI) said on Friday that its foreign exchange reserves topped the $350 billion mark in the week ended 1 May. That is nearly $56 billion more than what it had in the beginning of May 2013. And more than $76 billion over what it had immediately after the run on the rupee that year. And the quarterly current account deficit has fallen from $21.8 billion in April-June 2013 to $8.39 billion in October-December 2014 (the latest quarter for which data is available).
What this means is that India is in a far better position to fund its net imports even if foreign capital inflows dry up for a few months.
The Indian central bank deserves credit for buying dollars when foreign capital was rapidly flowing into the economy. We had argued in thesecolumns in January that India needs to build a $500 billion war chest, although we had also added that such heavy intervention in the foreign exchange market would compromise the independence of monetary policy given the open capital account. By buying all those dollars, India in effect avoided the mistake it made after 2010 of allowing the rupee to appreciate in nominal terms rather than intervene to build reserves.
The rupee has also begun to weaken. That is not necessarily bad news. The currency has been steady against the dollar in nominal terms but it has appreciated in real terms because of high domestic inflation compared to the rate of price rise in competing economies. The global economy continues to be weak but a fall in the rupee could provide a temporary boost to net exports at a time when the two domestic sources of effective demand (consumption and investment) are struggling.
India has better economic fundamentals than it did two years ago. It also remains a bright spot in a clouded global economic landscape. None of this means that India will not be affected by global financial turbulence, especially in case it turns serious. Indian policy authorities should allow the rupee to depreciate, stay focused on keeping inflation down and push ahead with economic reforms that strengthen the underlying growth driver.
The fall in the rupee is an overdue adjustment given our high inflation. The ruling Bharatiya Janata Party has had a long tradition of treating it as some national disaster. Prime Minister Narendra Modi should prepare to deal with the economic nut cases and yoga gurus who could soon emerge out of the woodwork to trot out their usual paranoia about how a fall in the rupee is a sign of an impotent government.
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