Thank god the cool-headed RBI isn't propping up the rupee

The rupee's sharp fall of recent weeks against the US dollar has been arrested - and even marginally reversed - this morning by an improvement in risk sentiment.

News of a likely loan lifeline from the IMF to Italy, and of a larger rescue mechanism, have buoyed up investor sentiment and the rupee, which had been battered by the avalanche of bad news out of Europe in recent days.

The turnaround in sentiment has come not a day too soon, since the chorus of voices demanding an intervention by the RBI to prop up the rupee was becoming a little too loud and a little too shrill. In UBS economist Jonathan Anderson's theatrical characterisation, the rupee is a "drama queen", given to hysterical excesses and dramatic flailing of limbs.

The RBI had indicated that while it would step in during periods of excessive currency volatility to smoothen things out, it wasn't about to prop up the rupee. That principled position, based on pragmatic considerations of the market situation, wasn't always appreciated.

Today's trend reversal in the rupee's value, however minuscule, validates the RBI's stand on the underlying reasons for the rupee's slide. Reuters

The rupee's slide of recent days was, as Firstpostargued here, largely a function of the heightened risk aversion (and a flight to the relative safety the US dollar) although some elements of India's deteriorating macro economy were also to blame.

We had said then that once the hysteria over Europe abated, the rupee would turn around, even if it doesn't quite leap back to its earlier values. That view, and the RBI mandarins' cool head when all around them were losing theirs, has been borne out by today's trend reversal.

Rating agency Moody's too has commended the RBI's "restraint" - that is, its unwillingness to intervenein the currency market - as "credit-positive" for India. The agency's chief India sovereign rating analyst Atsi Sheth notes that that the RBI had, rather than aggressively selling dollars to reverse the rupee's depreciation, limited its intervention to periods of extreme volatility.

For sure, a falling rupee brings bad news. "The immediate effect of a falling rupee is clearly negative for unhedged importers and borrowers in foreign currency," points out Sheth. "Moreover, it raises the government's petroleum products related subsidy burden, widening an already high fiscal deficit."

And the currency depreciation was also further adding to inflation, which was already above 9 percent.

Yet, the RBI authorities' decision "not to spend large quantities of international reserves to support a higher rupee over the past three months is credit positive for two reasons," reckons Sheth.

First, an intervention would have used up foreign exchange reserves - without meaningfully reversing the depreciation, since global risk aversion and India's widening current account deficit would have forced the rupee to fall further against the dollar despite the intervention.

Second, notes Sheth, effective globalisation requires market participants to adjust their investment, consumption and borrowing plans according to the availability of foreign capital and import costs.

Over the past few years, external borrowing by Indian firms has risen significantly in response to the differential between higher domestic and lower foreign interest rates. Foreign borrowing has also funded rising imports.

The recent currency depreciation highlights that exchange rate risk, along with interest rate differentials, ought to be incorporated into private sector decisions about external leverage.

If the RBI had authorised the use of official foreign exchange reserves to maintain the exchange rate at a level higher than dictated by market forces, they would have assisted importers and foreign borrowers - at the expense of exporters and domestic producers competing with imports, reasons Sheth. This would have delayed or distorted private sector adjustment to global market signals.

In her estimation, currency depreciation would ultimately force an adjustment by making imports more expensive and exports cheaper - and thus help narrow the current account deficit over the next few quarters.

Of course, if inflation in India remains higher than in its trading partners, it would limit the extent to which a rupee depreciation would enhance Indian export competitiveness. In any case, the anaemic growth projections to the global economy paint a rather tepid outlook for export growth.

The RBI's other actions intended to arrest the steep decline in the rupee - such as the relaxation of capital controls, and the raising of caps on interest rates on non-resident Indian depots, on commercial borrowings and on foreign participation in domestic bond markets - would help support the rupee, or at any rate check its precipitous decline of recent days.

Yet, it's hard to see a sustained appreciation of the rupee so long as the current account deficit widens and global risk aversion remains high.

There's nothing to say that the rupee won't slide back if eurozone panic is accentuated again in the event the the rescue plans don't materialise in the manner that they've been announced. But today's trend reversal in the rupee's value, however minuscule, validates the RBI's stand on the underlying reasons for the rupee's slide, and the fact that panicky intervention - of the sorts that some commentators had sought -would have only compounded the problem.

Perhaps it's time for the back-seat drivers to mute their commentary - and allow RBI honchos to get on with what is decidedly a challenging task in a volatile environment...