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THE GIST of Editorial for UPSC Exams : 10 September 2018 (The rupee is falling and India should let it)

Mains Paper: 2 | Economic Development
Prelims level: Currency valuation
Mains level: The Reserve Bank of India’s stated policy is to reduce volatility, rather than target a specific level for the currency.

Introduction :

In 2016, RBI had been given a new mandate to meet its inflation target and maintain growth.
Defending the currency at all costs isn’t part of the brief.
The Indian rupee has been sliding against the US dollar in recent days as emerging markets come under pressure.
That’s made the currency one of Asia’s worst performers, losing 12% this year.
The Reserve Bank of India’s stated policy is to reduce volatility, rather than target a specific level for the currency.
Should the RBI intervene to strengthen the rupee? If so, what precisely should it do and what would the impact be?

Needs to strengthen the rupee :

A number of factors are pressuring officials to act not least among them, that the rupee has become both a badge of national pride and a tool of political brinkmanship.
But so far the government and the RBI have been unruffled by the fear-mongering.
Some of the loudest complaints have come from companies fretting about the likely impact currency depreciation will have on corporate balance sheets.
Those who bet RBI would step in when faced with depreciation pressure borrowed heavily in international markets.
Yet India’s currency-derivative markets, with many restrictions and limited liquidity, make hedging quite expensive, so these companies are now exposed.
The price of oil, which quickly becomes a matter of unhappiness among the middle class.
India imports about 80% of its petroleum needs, a factor only complicated by the country’s exorbitant domestic taxes on fuel—almost 100% on petrol and 60% to 70% on diesel.
This means that when the rupee depreciates, the exchange rate pass through to fuel prices and, as a result, the rest of the economy, is high.

What RBI can do? :

The RBI does have a number of instruments it can use to support the currency.
The most obvious is to intervene in foreign exchange markets by selling dollars: the central bank has more than $400 billion in reserves at its disposal.
Alternatively, it could raise interest rates, a move justified by the currency weakness, higher oil prices and the latest above-target inflation data.
It could raise dollars by borrowing from non-resident Indians, which has become a go-to in times of currency stress.
Every move—from tightening liquidity and raising interest rates to discussion of non-resident borrowing and restrictions on derivatives.
It was interpreted as a panic reaction that only confirmed the rupee was under pressure.
Foreigners felt it was better to take money out of India sooner rather than later, and the fall of the rupee became a self-fulfilling prophecy.
Currency and derivatives markets, money and credit markets, and high costs of borrowing all hurt the economy in subsequent months.
In the years that followed, RBI continued to manage the rupee carefully.
It mostly achieved this by reducing the size of the rupee-dollar derivatives market, which made its intervention more effective, and then buying rupees forward.

Way Forward :

To some extent, the approach worked: currency volatility settled.
While the real exchange rate of the rupee appreciated, the currency didn’t weaken in line with India’s higher inflation.
Yet some could argue this merely set the stage for the current rout, which can be seen more as an overdue recalibration than a flash in the pan.
There are some segments of the economy that gain from rupee depreciation.
A weaker currency helps export growth, which has been weak in recent years.
A weaker rupee would also offset competition of cheap imports from countries like China, which could give domestic industries a much-needed boost.
The RBI and India’s government, at present, are calm.
This is a strong posture that must withstand the daily news, media pressure, lobbying and political taunting.
In 2016, RBI had been given a new mandate to meet its inflation target and maintain growth.
Defending the currency at all costs isn’t part of the brief. This latest weakness will test its resolve.

UPSC Prelims Questions:

Q.1) Devaluation of currency means the reduction in the value of a currency vis-à-vis which of the following ?
A) The prices of the major commodities
B) The value of a particular currency
C) The value of major internationally traded currencies of the world
D) None of the above
Answer : C