Ajit Ranade: Rupee depreciation is inevitable but exchange-rate volatility is not

This is the shadow impact of the exchange rate. An open economy with a tradeable sector is subject to competition from goods and services traded internation-ally. The exchange rate thus affects its competitiveness, a lack of which cannot be compensated fully by raising import-duty protection; it is eventually counterproductive because tariffs lead to inflation as locally produced protected goods get expensive.

Inflation is the other most important economic variable. To keep it in check, interest rates must rise. This delicate dance between the three variables of inflation, interest rates and the exchange rate is a major headache for policymakers. It is governed by the ‘impossible trinity’ theorem, which says that you cannot have independent control of both the exchange rate and interest rate and still maintain an open economy.

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In other words, a fixed exchange rate and free capital flows are incompatible with an independent monetary policy, thus compromising the nation’s autonomy. Despite this so-called trilemma, it is still possible to have partial control of exchange and interest rates and keep the economy partially open. This is the art of policymaking—what economists call ‘interior solutions’ (i.e., not corner solutions).

The Reserve Bank of India (RBI) is technically only a custodian of our foreign exchange reserves, but it also manages the exchange rate. RBI has a written explicit inflation mandate but no numerical target for the dollar rate, which in any case would be futile. RBI maintains that it lets market forces determine this rate and intervenes only to curb excessive volatility.

The challenge of managing the exchange rate has other dimensions too. For instance, India’s economic growth needs exports as a driver. An exchange rate that is too high can hamper exports. For the past few years, our exports have grown slower than GDP, which needs to be corrected. How much exports have suffered due to a high rate is debatable. Did it remain high because of intervention by RBI?

Former chief economic advisor Arvind Subramanian and Josh Felman find that for past three years, the real effective exchange rate (REER) has been kept much higher than the average for the previous two decades. The REER is calculated by adjusting the nominal rate for differences in inflation with India’s trade partners.

They point out that unlike in the previous two decades till 2019, the rupee was actively prevented from depreciating by aggressive sales of India’s stock of foreign exchange. From February till October of 2022, RBI sold or lost a whopping $105 billion of its stock. This was presumably to prevent the rupee from sliding. Was this not an excessive cost to pay to prevent what should have been a natural decline?

Also read: What a weakening rupee means for India – and your portfolio

There are two aspects to RBI’s stock and sale of dollars. On one hand, a large stock represents a cost to the nation in foregone higher returns that could have been earned on non-dollar assets. Conversely, when RBI sells aggressively at a lower rate than when it bought the dollars, it makes a net profit, which can be passed on as annual dividend to the government.

Estimates of the cost of excess holdings and profit from excessive selling are not readily available. An average holding of $700 billion with a 3% interest differential implies a cost of $21 billion (or about ₹25,000 crore). On the other hand, RBI’s dividend payouts have been huge in recent years, which was a result of extra dollar sales as well as a reduction in the risk buffer.

Invoicing is another dimension of forex policy. While only about 15% of India’s trade is with the US, nearly 85% of foreign trade is invoiced in US dollars. This too has an impact on the dollar’s global strength.

In the era of a second Trump presidency and sky-high US debt and budget deficits, the strength of the dollar cannot be stopped easily. In the early 1970s, the US Treasury secretary had quipped that “the dollar is our currency but your headache." That is no longer true. President Trump would want the dollar to weaken, a wishful thought against the mighty global tide.

For India, there are other options, like reducing dollar invoicing, convincing some trading partners to accept rupee payments (like done already for Iran and Russia), or diversifying into non-dollar reserves. This is easier said than done.

Hence, the only prudent thing to do is avoid too much active intervention and only focus on volatility control, as was done during 2008, 2011 and 2013 in three different episodes of disruptive capital flows. Holding the rupee too strong hurts not only export prospects, but also the competitiveness of purely domestic businesses, given the shadow threat of imports.

Let RBI be restrained in active forex management and aim for gradual depreciation, which is inevitable. Meanwhile, some other non-RBI policy responses designed to strength the rupee would include enticing higher foreign direct investment inflows, keeping the domestic growth rate high and reducing our dependence on imported crude oil.

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All this would be in the domain of New Delhi rather than Mint Street. It would also help to tone down the rhetoric of equating the rupee’s strength with national strength.