By Jamal Mecklai
The IMF has reclassified India’s de facto exchange rate regime to “stabilised” from “floating” over the period December 2022 to October 2023. The Reserve Bank of India (RBI) has strongly disagreed with this characterisation, terming IMF’s analysis as being extremely short term—over a longer period (say, 2-5 years) the picture would be quite different.
On December 1, 2022, USD-INR was at 81.02 and DXY was at 105.66. From the graphic, it is clear that the RBI has been on the job of weakening the rupee full-on. Owing to absent RBI action and with the admittedly imperfect assumption that a free-floating rupee would follow DXY exactly, the rupee would have been a huge 3.7% stronger (on average) than it was in reality. And on October 31, 2023, it would have been at 81.59, 2% stronger than the actual 83.26.
It seems clear that RBI’s actions were directly focused on trying to keep the rupee weak so it could be more competitive for exports. Equally clearly, the much-repeated “the RBI intervenes only to smoothen exchange rate volatility and prevent disruptions from taking place”, as articulated by Arun Jaitley in 2014, and “RBI has no fixed level it is trying to protect, it only acts to control volatility”, which has been repeated ad nauseam by several RBI governors and deputy governors since, were simply part of the communication game.
Of course, exchange rate management is not that simple a game. If the rupee is kept “artificially weak”, you can be sure that inflation will become “artificially high”, and part of the skill is in playing export competitiveness off against this risk.
As we all know, inflation has been the number one macroeconomic problem both globally and in India for at least 18 months. However, with things having settled reasonably on the inflation front in 2023—average inflation in fiscal 2023, at 5.46%, was down from that in fiscal 2022 (6.78%) and below the high end of RBI’s target band of 6%—it made sense for RBI to weaken the rupee to assist export competitiveness, which has been sluggish over the past several years.
However, with the dollar (DXY) strengthening from mid-August 2023, the balance must have shifted to where the “independent” RBI needed to protect its gains on inflation—reinforced by the fact that the country was going into a major election cycle. The RBI had to prevent the rupee from falling further and, between August and October 2023, it intervened heavily selling dollars; its reserves fell by nearly $16 billion, dwarfing the portfolio outflows of about $3.5 billion over that period. The rupee was pulled up tightly at right around 83 to the dollar—indeed, if the rupee had followed DXY over this period, the rupee would have been at 84.39, 1.4% weaker than its close on October 31.
Again, another impact of all of this action was that the volatility of rupee, which had been falling from about 6% in December 2022, collapsed sharply and, since August 2023, has slid to an all-time low of just below 2%. Now low volatility in and of itself is a good thing provided it is “natural”. However, if it is designed, as in the case of the rupee, it leaves the market open to moral hazard and, possible serious losses if things turned the other way—if there is some kind of global crisis or if the dollar simply rises sharply.
RBI’s good fortune is that the dollar has started weakening again and with global inflation on the decline and asset prices rising, portfolio flows have been pouring into the country. Significantly, the reserves have risen by $19 billion since November, far exceeding portfolio flows, which brought in just $8.5 billion over the period. Clearly, the RBI has been buying dollars again.
And so it goes round the mulberry bush. To my mind, the RBI needs to set a minimum volatility level to ensure that Indian companies can make sound decisions on risk management. In the current environment, most importers feel that even at these low premiums it is not worth hedging and try to time the market. Exporters, too, unable to forget the tasty premiums of the past, are generally reducing their hedge ratios and/or their risk management tenors.
The RBI needs to remember that its primary job is to create a sound market for risk management. I think these are the kinds of things the IMF was trying to point out.
(The author is CEO, Mecklai Financial)