The sharp fall in the rupee in the last four months and especially in the last four weeks has brought back the debate on the RBI's role in exchange rate management.
Almost since the Jalan era the RBI has repeatedly said it doesn't try to target any level for the rupee, that it allows the rupee to be market determined and only intervenes to smooth out volatility. But in reality the RBI has been way more interventionist. It has always actively and tacitly sought to determine the purchasing power of the rupee both at home and abroad.
Given the deficits in trade and current account and that India's inflation has structurally been higher than that of most of its trading partners, the RBI has actively sought to ensure that the exchange rate is kept within a 5 percent band of the Real Effective Exchange rate or REER. This band has expanded over time to may be 10 percent, given the rising globalisation of the country and the volatile nature of capital flows.
The very reason that the RBI accumulated reserves throughout 2004 to 2008, indicates that it actively sought to keep the rupee from appreciating too much. Short point, much like China, India has believed that the exchange rate needs to be actively managed to ensure the country's tradeable sector remains competitive and the deficits are at manageable levels.
However, since 2009, although the explicitly stated exchange rate policy of the RBI remains the same, there has been a marked shift in its behaviour. The divergence between walk and talk has disappeared and the RBI appears to be genuinely allowing the market to determine the dollar-rupee value. One consequence of this has been the fact that India hasn't built on its reserves.
"UBS points out that India's net reserve cover - foreign-exchange reserves plus the annual current account balance, minus short-term external debt - which was at 14 percent of GDP in 2008 fell to 9 percent in 2009."
Similarly, reserves as a ratio of the annual current account deficit is falling. Some argue this has made the rupee a higher beta currency when global risk appetie is low. The second consequence is more invisible and more long lasting. Export and import substituion are both hit when the currency remains stable in a context of high domestic inflation and this may well have caused the widening of the trade deficit by September. Infact the real effective exchange rate of the rupee was overvalued by 19 percent versus its six major trading partners and by 5 percent vs its 36 trading partners in July. Both at 19 percent and at 5 percent the overvaluation of the REER appears to have been at near all time highs, previously scaled only in financial year 2008.
Going by the decades-long policy, RBI should have tacitly intervened at least through June and July to pull down the rupee, since in real terms the rupee wasn't at 44 by July end but probably 42. The big September trade deficit in this backdrop was an invitation to short the rupee, and more so because of the repeated and no-holds barred declaration of the RBI that the currency shall be market determined. The cost of this policy is now well documented.
Going forward, I would argue the RBI should resort to its old practice of actively keeping the exchange rate closer to the REER. Given that Europe is on the brink of a recession and the world in the throes of a long lean patch, exports and import substitution will need all the help. I would argue it is time for a tacit return to the pre-2009 activism on the exchange rate front.
As an aside, note one positive fallout of this scare the rupee created. Politicians and bureaucrats from Delhi and industrialists and technocrats from Mumbai will hencseforth desist from making their old and indefensible pitch that forex reserves should be lent to infra companies.