Managing currency risks

Adjustment in the rupee exchange rate should not be delayed

Economists at the Union Ministry of Finance have done well to highlight the emerging twin-deficit risk. While the government’s revenue will be hit because of the reduction in duties on petroleum products, it is expected to incur higher expenditure, which could worsen the fiscal position. A higher fiscal deficit could widen the current account deficit (CAD) and put further pressure on the rupee. Currency management thus could become a bit tricky in the near term. India’s external account is under pressure, partly because of higher commodity prices. Capital flows that help finance the CAD are also witnessing a reversal due to the sudden tightening of global financial conditions. Higher inflation in the developed world is forcing central banks to withdraw monetary accommodation. The US Federal Reserve, for instance, raised the policy rate by 75 basis points last week — the largest increase since 1994. Since it is expected to continue to increase rates, global financial conditions would tighten significantly in the coming months.

Monetary policy in the developed world, particularly the US, materially affects capital flows. Increasing rates in the US are pulling capital from the rest of the world, putting other currencies under pressure. The Indian rupee, for instance, has fallen about 5 per cent since the beginning of the year. Since the dollar index has gone up by about 10 per cent this year, currencies from emerging and some developed markets have seen significant sell-offs. In the Indian context, according to research by economists at the Reserve Bank of India (RBI), there is a 5 per cent chance that portfolio outflow could be 3.2 per cent of gross domestic product (GDP), or $100.6 billion in a year. This could be in response to a Covid-type contraction in GDP, or global financial crisis-type decline in interest rates differentials with the US, or financial crisis-like surge in volatility. In an extreme risk scenario, the outflow could be worth 7.7 per cent of GDP. This would put significant pressure on the country’s external balance. Foreign portfolio investors sold assets worth more than $29 billion so far in 2022.

The RBI, however, seems to be defending the rupee to a great extent and has seen reserves go down by over $37 billion so far in 2022. The data compiled by the RBI in its recent monthly bulletin showed that while the rupee declined by 1.5 per cent in May, the currencies of China, Brazil, and South Africa declined by 4.3, 4.5, and 5.4 per cent, respectively. While there is merit in containing volatility, defending the rupee could affect competitiveness and increase risks. However, intervention in the currency market might help the RBI attain other objectives, such as containing imported inflation and draining rupee liquidity from the system. Lower liquidity, which is desirable, given the inflation condition, would also enable the RBI to intervene in the bond market and gain better control over the yield curve.

However, restricting currency adjustment could create broader macroeconomic risks and worsen the external balance. Since the present conditions are likely to persist, the rupee should be allowed to gradually depreciate. Adjustment in currency movements is a better way of stabilising the CAD than random restrictions on imports. This is not to suggest that the RBI should not intervene at all because a fall in currency can become self-fulfilling, but the adjustment should not be delayed to attain other objectives.