As the Rupee broke through 81 against the US dollar Intraday on Friday, policymakers in New Delhi find themselves in a quandary as the Reserve Bank of India (RBI) has burned foreign exchange reserves at a dramatic pace this calendar year to stem exchange rate fluctuations — an intervention many market participants believe will that it is defending the currency at a certain level.
In just eight months, between mid-January and mid-September this year, foreign exchange reserves have declined by almost $90 billion, or about an average of $11 billion per month. For the weekend ending September 16, India’s foreign exchange reserves were US$545.65 billion compared to US$634.97 billion for the weekend ending January 14.
“How long?” asked the CEO of a foreign institutional investor (FII), who asked not to be named. While persistently high inflation of over 7 percent has prompted the RBI to raise interest rates, the government is keen to maintain GDP growth and create more jobs as several major states head to polls over the next 12 to 18 months .
After multiple agencies slashed GDP growth forecast to 7 percent and below, the Union Treasury finds itself in a dilemma over whether aggressive monetary tightening is the appropriate strategy for India, which faces challenges that may require a different response than the western countries. In this regard, Finance Minister Nirmala Sitharaman has previously said that “the RBI may not be as synchronized as Western countries would be” – in other words, raising interest rates may not be best for India.
Explained
Rough road ahead
With elections in over a dozen states over the next 12 to 18 months, the government is weighing on GROWTH imperatives and the need to create jobs. Policymakers would rather allow the rupee to depreciate rather than sharply raising interest rates to curb inflation.
Politicians in government and RBI are convinced that a large part of inflation is “imported”. They discuss the relative merits and demerits of an ‘overt’ measure such as a rate hike versus a ‘covert’ gradual depreciation of the rupee. “As opposed to tightening through rate hikes, which is akin to using a sledgehammer, letting the rupee find its level to rein in demand is a better tool,” said an official who asked not to be named. A depreciating rupee makes imports more expensive and dampens demand.
A depreciating rupee makes imports more expensive and dampens demand.
According to RBI’s April 2022 monetary policy report, a 5 percent depreciation of the rupee could lead to a 20 basis point increase in inflation, while GDP growth could be 15 basis points higher. Year to date in 2022, the rupee has depreciated 8.2 percent against the US dollar. Policymakers in New Delhi seem to be turning away from the view that the RBI should not sacrosanctly hold any particular level. “This (gradual weakening of the rupee) covert action is better than an overt monetary policy action to hike rates,” said one policymaker who asked not to be named.
“Even today the rupee closed above 81,” said a senior FII official, pointing to the central bank’s reluctance to let the rupee slide. The Indian rupee broke through 81 for the first time against the US dollar on Friday before settling at 80.98 as the greenback continued to strengthen against all other major currencies following an aggressive announcement of a rate hike by the Federal Reserve.
In two days since the Fed’s announcement on Wednesday, the rupee has lost 1.5 percent.
It opened at a record low of 81.03 against the US Dollar compared to the previous close of 80.86. The domestic currency fell to a daily low of 81.22 per US dollar. The rupee’s weakness also dampened investor sentiment in the stock market, with the benchmark Sensex at BSE falling sharply, down 1020 points, or 1.7 percent, to close at 58,098.9. The broader Nifty on the NSE slipped 302.45 points or 1.7 on Friday to close at 17,327.3. In the last two trading sessions, the two indices have lost over 2.2 percent.
The house is already divided over the magnitude and pace of the RBI’s rate hikes. There are early but discernible signs of disagreement between the government and the central bank over the central bank’s policy action to curb inflation versus the central bank’s need to restart growth. RBI’s three-day monetary policy committee is scheduled to start on September 28, with action to be announced on September 30.
North Block is known to be more inclined towards a dovish pace of RBI rate hikes than an aggressive stance from developed market central banks, as inflation is mainly driven by global factors and other concerns about employment and sluggish investment adoption, which prevails over inflation.