ISSN (Print) - 0012-9976 | ISSN (Online) - 2349-8846

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Exchange Rates, Markets and the RBI

Recent developments in the foreign exchange and money markets have shown that if the Reserve Bank wishes to pursue an independent monetary policy, one tailored to suit the cyclical conditions of the domestic economy, it needs to step back from its interventions in the foreign exchange market and let the rupee be.

In the first week of April, the RBI announced, through a quartet of rate cuts, including a full percentage point reduction in its bank rate, its shift to an easier monetary stance. While there was some uncertainty as to how long this stance would last, in the immediate term, nevertheless, the signal carried, and through April nominal interest rates softened across the board. In contrast, though as anticipated, on May 16, the US Fed hiked its overnight borrowing rate, thus signalling its shift to a tighter monetary regime. With nominal interest rates moving in opposite directions in the two countries – up in the US and down in India – a fall in the value of the rupee against the US dollar was inevitable unless, of course, the RBI signalled its willingness to revert to a tighter monetary stance. This it did not do, at least not in the first few days following the Fed’s announcement. As a result, sentiment in the foreign exchange market turned bearish, and traders began moving from rupee to dollar positions. While the Reserve Bank may not condone such behaviour, it must nevertheless admit to its rationality as, at the time, all short-term fundamentals favoured the dollar. With market players moving against the rupee, cautiously at first and then, in the absence of any signal from the RBI to the contrary, much more aggressively over the next few days, the rupee’s slide against the dollar rapidly gained momentum. How far or how long this would have continued before the market self-corrected, one will never know, for on May 25, the Reserve Bank stepped in with a set of defensive measures aimed at stemming the rupee’s fall. Since then, the foreign exchange market seems to have calmed down somewhat, albeit around a significantly depreciated rupee-dollar rate.

There are, however, no free lunches. While, by its intervention, the Reserve Bank may have succeeded in limiting volatility in the for-ex market today, the costs it has incurred in the process are likely to make its task of macro-management that much more difficult in the immediate, as well as more distant, future. Consider, thus, its task as a manager of the public debt. As is well known, the government has a huge borrowing programme slated for the year. Efficient management of this programme requires, at the very least, a buoyant gilts market. But at present the gilts market is completely moribund, thanks largely to the RBI’s desire to ensure orderly movements in the rupee-dollar rate. In the statement released on May 25, the RBI went to considerable effort to emphasise that “it does not, repeat, it does not, target any particular value of the rupee in relation to the US dollar”, rather it merely manages it. Its distinction between targeting and managing the exchange rate may, however, be overdrawn, because, as the markets well know, the only way the Reserve Bank can manage the exchange rate today is by letting its monetary policy be subservient to its ‘managed’ exchange rate objectives. Consequently, by stepping in to stem the rupee’s fall, the RBI immediately signalled to the market its willingness to tighten liquidity in pursuit of its objective. By its actions, thus, it succeeded merely in shifting the locus of uncertainty, from exchange rates to interest rates. With the outlook on interest rates uncertain, transactions in the debt market have dried up. Traders have begun off-loading gilts in the secondary market, yields on government and corporate paper have hardened and, despite announcing significantly higher cut-off yields, the Reserve Bank is finding few takers for new government issues. By its foreign exchange intervention, thus, the RBI has compromised its role as a manager of the public debt. But this is the least of it. By letting its monetary policy be dictated at this stage by its exchange rate objective, the Reserve Bank has eroded its credibility in a manner that it can ill afford.

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