Rupee and RBI: A match not made in heaven

We have all heard about the depreciation of the rupee against the dollar lately. At around 78.06, the rupee has depreciated by more than 5% over the past year. But the depreciation of the rupee is not something unheard of. Since 1991, the INR has constantly depreciated against the dollar.

Since 1991, we have adopted the Liberalized Exchange Rate Management System (LERMS), the floating exchange rate system. In such a system, RBI frequently intervenes to manage the currency by buying or selling foreign currency in the open market. This is done to ensure the stability of the country’s balance of payments (record of all monetary payments between a country and other nations during a given period).

While the depreciation of the Rupee against the Dollar is well known, what most of us do not know is that the INR has strengthened by 7% against the Euro over the past last 12 months.

But why do we care so much about the EUR or any other currency against the USD?

The answer is the real effective exchange rate (REER) of RBI for 40 countries. It is the measure of RBI to measure the relative competitive strength of the Rupee and the Euro characteristics in first position in India trade based weighting and only marginally second to USD in India based weighting exports.

What is the RRSP?

Before we get to RRSP, let’s first understand what NEER is. Wait, we know we’re just confusing you, but spare us a minute!

The nominal effective exchange rate or NEER is an index of the weighted average of the bilateral exchange rates of the national currency vis-à-vis the currencies of the trading partners. The weights are derived from their shares in the national currency trading basket. So, if India trades with only the US and Europe, the NEER will be the weighted average of and with weights according to the proportion of trade with the two countries.

The REER is nothing but the NEER adjusted for the inflation differential between the national economy and its trading partners.

Without going too far into the real calculation of the REER, in simple terms, it is an effective exchange rate that assesses the fair value of a currency or the external competitiveness of an economy vis-à-vis its Commercial Partners. It serves as a guide to the monetary and financial policy strategy of the central bank.

India’s REER is based on a basket of currencies of 40 countries that reflects the country’s major foreign trading partners.

In May 2022, India’s RRSP was 115.3 compared to 113.7 in April and an all-time high of 118.3 in November 2017. For your information, an increase in RRSP indicates a reduction in India’s competitiveness. economy, which is not good.

The Role of RBI in Currency Management

RBI has always been adamant that it does not target any specific rupee level and only intervenes when there is excessive volatility. However, RBI often does NOT let the market find its level. This is the case during the pandemic period.

In the financial year 2021, India has seen an increase in foreign money flowing into the country. This led to a sharp shift in the current account balance (the sum of net trade in goods and services and remittances) from a deficit of $25 billion in FY20 to a surplus of $24 billion. in FY21. Total net flows, including FDI (foreign direct investment) as well as REIT (foreign portfolio investment), had reached a record high of $107 billion. RBI consciously swallowed massive dollars in open markets to prevent the rupee from appreciating below 72.0

Had it not happened, a sharp appreciation of the rupee would have hit investors with currency exposure, including those considering investing in India. It would also have hurt exports and made imports cheaper, further hurting domestic manufacturers during a pandemic. So, it looks like RBI did the right thing.

Now what?

Currently, we are in a completely opposite situation. We are currently witnessing huge currency outflows. Our FY23 current account (CAD) deficit could be around $100 billion. Amid ongoing geopolitical tensions and supply chain issues, we don’t see a major return to these flows anytime soon. So, should RBI now do the opposite and use its coffers to sell dollars to stop the rupee’s fall now?

We do not believe that RBI will intervene too much to use its foreign exchange reserves to fight depreciation as this could lead to external instability. Even though RBI has large foreign exchange reserves of about $600 billion, which is about 20% of GDP, but any drop below 15% (to $450 billion) could cause panic.

So the RBI can let the INR weaken gently. Why is it so? To correct the overvaluation of the INR in terms of the REER and somehow prepare for possible stress scenarios through an improvement in the national economy and an increase in exports (helped by the weakness of the rupee). This could well mean that the USDINR weakens further or even breaks through 80.

Another reason why the RBI may not be intervening much is that the depreciation of the Rupee is attracting many FIIs through both the FDI and REIT routes. Historically, each round of rupee depreciation was followed by a stock market rally. Thus, RBI could let the Indian rupee stabilize on its own without too much intervention for change.

This policy seems very ad hoc, and we couldn’t agree more. It is high time that we reflect on the implementation of a global currency management policy, aligned with monetary policy to better prepare us in these difficult times.

Disclaimer: The above analysis is just for informational purposes.

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