Unshackle the Rupee (GS Paper 3, Economy)
Introduction
- While the recent performance of the Indian rupee (INR) against the US dollar has been lauded for its stability, this seemingly favorable trend conceals a troubling reality.
- The apparent stability is largely the result of substantial intervention by the Reserve Bank of India (RBI) in the foreign exchange market, a strategy that raises important concerns about the long-term health of India's economy.
Background on RBI’s Currency Intervention
The Reserve Bank of India (RBI) has a long history of intervening in the forex market to manage rupee fluctuations, particularly during periods of volatility. However, the scale of RBI’s recent interventions has been unprecedented since the 1991 economic reforms.
- Historically, the average annual volatility of the INR-USD exchange rate was around 5% over the two decades leading up to 2020.
- Between April 2023 and August 2024, this volatility dropped significantly to just 1.9%, signaling an even tighter control by the RBI. While a stable exchange rate is often seen as a positive, such low volatility is typically the result of central bank intervention rather than natural market forces.
Ideally, exchange rate stability, as seen with the Euro-dollar pair, is achieved by market forces, not central bank actions. The ECB (European Central Bank) and the Federal Reserve do not engage in direct interventions, allowing market dynamics to determine the currency's value. By contrast, RBI’s actions have created a scenario where the rupee is artificially stabilized.
Recent Change in RBI’s Currency Policy
Since late 2022, the RBI has actively intervened on both sides of the foreign exchange market:
- Buying US dollars to prevent the rupee from appreciating.
- Selling US dollars to prevent the rupee from depreciating.
This approach has essentially created an informal dollar peg, where the rupee’s value is maintained within a narrow band relative to the dollar, without an official announcement or clear policy framework.
The RBI's increased market intervention is aimed at protecting exporters and preventing the rupee’s appreciation, which would make exports more expensive. At the same time, it aims to prevent depreciation that could lead to inflationary pressures, especially on imports.
Problems with the New Currency Policy
Economic Principles: Contradiction to Free Market Dynamics
The crux of the problem with the RBI’s approach is that it contradicts fundamental free-market principles:
-
- Market-driven exchange rates are the basis of a functioning economy. Exchange rates are meant to reflect supply and demand, which provide crucial signals about the health of an economy.
- State-controlled prices, including currency values, distort these market signals. When central banks step in to control currency movements, they obscure the real state of the economy and disrupt the price discovery mechanism.
By artificially stabilizing the rupee, the RBI is preventing the market from accurately reflecting economic realities. This could undermine investor confidence and mislead businesses about the true cost of doing business in India.
Historical Lessons: The Danger of Pegged Exchange Rates
India's pre-1991 experience with a controlled exchange rate is a cautionary tale. During this period:
-
- The pegged rupee led to foreign exchange shortages, creating distortions in trade and investment.
- The 1991 balance of payments crisis was a direct consequence of these controls, highlighting the risks of artificially maintaining exchange rate levels.
Similarly, other countries that have attempted to maintain pegged or managed exchange rates have faced severe consequences. Argentina, Brazil, Mexico, Russia, South Korea, Thailand, and Turkey all experienced crises tied to their pegged or over-controlled exchange rate systems.
These historical lessons indicate that such interventions can lead to unsustainable currency values and economic instability.
Practical Issues: Losing the Benefits of a Flexible Exchange Rate
The previous flexible exchange rate regime in India had several advantages:
-
- Smoothing Business Cycle Fluctuations: A market-determined exchange rate helps smooth out fluctuations during different phases of the business cycle. During periods of high growth and capital inflows, the rupee naturally appreciated, helping to prevent the economy from overheating. During downturns, the rupee depreciated, making exports more attractive and promoting a recovery.
- Long-term Stability in Real Exchange Rates: Over the long term, a flexible exchange rate system helps stabilize the real exchange rate, which adjusts for inflation differentials between India and its trading partners. This balance between appreciation and depreciation helped maintain India’s competitiveness in global markets.
In contrast, the RBI’s new policy of tight currency control has already resulted in a real exchange rate appreciation, which makes Indian exports more expensive and could undermine India’s Make in India drive, which relies on affordable exports to drive economic growth.
Transparency Concerns
One of the major drawbacks of RBI’s current policy is the lack of transparency regarding its actions and intentions:
-
- The RBI has rarely communicated the rationale behind its currency interventions, leaving private sector participants in the foreign exchange market unclear about the long-term direction of the rupee policy.
- This lack of clarity creates uncertainty, especially about whether the current policy is temporary or a permanent shift. Without clear guidance, businesses and investors are forced to make decisions based on speculation rather than reliable economic signals.
Conclusion
- The value of a currency plays a crucial role in the overall functioning of an economy.
- A currency that is allowed to be determined by market forces provides accurate economic signals, which are essential for investment decisions, trade, and long-term growth.
- For India to achieve its ambition of becoming an advanced economy, its currency must reflect market fundamentals, not be artificially controlled.
- By unshackling the rupee and allowing its value to be determined by supply and demand, the country can ensure that it receives the correct economic signals, which will attract investment, promote exports, and maintain competitiveness.
- While short-term stability may seem beneficial, artificially controlling the rupee’s value could have adverse long-term consequences, both for India’s economic health and its global standing.
- The government and RBI must reconsider their approach and embrace a more flexible, market-driven system to unlock the full potential of India’s economy.
