In a nuanced counter to recent suggestions, a financial expert has argued that the Reserve Bank of India (RBI) should not abruptly stop defending the rupee. The central bank faces a complex optimization challenge, balancing the currency's fair value against potential shocks to trade, corporate health, and inflation.
The Perils of "Ripping Off the Band-Aid"
The debate centers on an editorial published on December 30, which proposed that the RBI allow the rupee to find its fair value through market flows. Tanay Dalal, Senior Vice President of Business & Economic Research at Axis Bank, disagrees with this approach. He references the years 2011 and 2013 as cautionary tales, where aggressive strategies led to a significant overshoot in rupee depreciation.
Dalal explains that the concept of "fair value" is akin to an equilibrium exchange rate, influenced by long-term shifts in trade and capital flows. Factors like the fall in global savings predicted by the IMF could reduce equilibrium capital inflows into emerging markets like India, pushing the Real Effective Exchange Rate (REER) down. However, the exact point of future equilibrium remains unknown and fluid.
Risks of a Sharp Currency Depreciation
A rapid devaluation, or "ripping off the band-aid," carries substantial risks for the Indian economy. Dalal highlights several key concerns:
First, corporate balance sheets, currently healthy, could be adversely affected. Since 2023, increased predictability in the rupee's movement has led to lower hedging volumes by companies. A sudden plunge could catch them off-guard, magnifying losses.
Second, a sharp fall would trigger a terms of trade shock, likely importing higher inflation. This would limit the RBI's ability to support economic growth through monetary policy.
Third, the benefits for exports are uncertain in the current climate of global trade frictions. If a weaker rupee doesn't significantly boost exports, the entire burden of economic adjustment would fall on the domestic economy.
The Case for a Gradual and Managed Approach
Instead, Dalal advocates for a strategy of gradually arriving at an indeterminate fair value while meticulously avoiding shocks. This involves the RBI managing the currency's path with care.
Part of this strategy could include introducing periods of limited two-way volatility. This would incentivize corporations to engage in more hedging activity. Dalal notes that limited hedging is known to exacerbate volatility, as flows rush to cover positions procyclically, forcing the RBI to dip into its foreign exchange reserves to restore stability.
A managed, gradual approach allows the RBI to approximate fair value over time, minimize the damaging effects of a rapid fall, and build greater inherent stability in the forex market.
The Role and Cost of Foreign Exchange Reserves
This strategy will inevitably lead to a drawdown in the RBI's effective FX reserve buffers. However, Dalal contends that smoothing long-term currency shifts while limiting economic damage is a primary reason these buffers exist.
Interestingly, he points to the IMF's Assessing Reserve Adequacy (ARA) framework, which states that reserve requirements increase with the level of control over the currency. This implies that once the rupee approximates a fairer value and gains greater freedom of movement later, the need to re-accumulate massive reserves would diminish. Thus, the entire exercise represents a pragmatic solution to the RBI's optimization problem, balancing multiple economic objectives.
