The Hindu Business Line : Lesson: RBI can stop the rupee on rise, not when it falls

The RBI cannot sell the dollar on the rise to bring down its value and raise the rupee value because, though the dollar is sold, the rupee will not rise. Will the RBI factor in this limitation in future and the advocates of a cheap rupee do a rethink, asks S. GURUMURTHY.

Many, including the Finance Minister, look unhappy when the rupee rises. They seem happy when it falls. But even they cannot quite enjoy the rupee’s 27 per cent plus fall against the dollar in the past 10 months. Market economics would usually explain any such fall in a short time as a correction of some earlier distortion. Here, that is not the case.

Between February 2002 and March 2008, all major currencies rose against a falling dollar in the range of 32 per cent to 79 per cent. But the rupee’s rise against the dollar then was not even one-fourth as rapid as the euro’s rise of 78 per cent or one-half as quick as the average rise of all currencies. Even weaker currencies with less bright fundamentals than the rupee, like the Malaysian ringgit, had moved up more rapidly than did the rupee.

The global currency map shows that as the dollar fell, the other currencies rose more rapidly against the greenback than did the rupee. But when the dollar rose, the rupee fell more rapidly than all other currencies against the dollar.

Why did the rupee rise less rapidly against the dollar when other currencies moved up twice to four times as fast as the rupee? And why did the rupee fall more swiftly against the dollar than did the other currencies?

It needs no seer to say that when the dollar was rapidly falling against all currencies from 2002 to January 2008, it was the Reserve Bank of India that did not allow the rupee to rise against the dollar as rapidly, and as much, as other currencies did.

Whenever the dollar supply exceeded the demand for it in the market, the RBI mopped up the extra dollars to ensure that the dollar did not fall and the rupee did not rise. To recapitulate, the central bank bought and added some $102 billion to build a forex fund of $192 billion between April 2002 and March 2007. The effect: a dollar cost an average of some Rs 47 in the year 2002-03, and was in the Rs 44-45 band in the four years from 2003-04 to 2006-07.

Justifiable reasons

Had the RBI not mopped up all surplus dollars in the market the greenback would have fallen below the band and the rupee would have gained as much. For four years, the RBI had literally put a brake on the rupee’s rise against the greenback, but for clearly justifiable reasons. The RBI had to build and keep a substantial forex reserve for three reasons:

One, India was running huge trade deficit.

Two, with volatile global oil prices, high forex reserves became a strategic need.

Three, a major part of forex reserves was floating money, like portfolio investments and non-resident Indian bank deposits, and so unreliable. The RBI had to balance the necessity for higher forex reserves with the need to ensure a stable exchange rate for the rupee.

The RBI exchange and forex reserves policies up to June 2007 had largely balanced the two equally important, and in a way inter-related, objectives. Does June 2007 have any significance? Yes, it does.

The position in June 2007 was this. The forex reserves had topped $200 billion. But despite the RBI monthly mop-up in excess of $3 billion in January-June 2007, the dollar slipped from Rs 45 in February to less than Rs 41 to a dollar in June, indicating a dollar glut in the market. Pressurised by the advocates of cheaper rupee, to recall again, the RBI mopped up $11.4 billion in the month of July alone — almost four times. Yet the dollar did not rise, but fell even further, to Rs 40.40. Here, the Finance Minister added his shoulders to stop the rupee rise. Result, from September 2007 to January 2008 — in five months, the RBI bought, in spot and forward, an average buy of $13 billion a month. Still the dollar fell, the rupee rose, to stand at Rs 39.30 per dollar. By March 2008, the forex reserve had moved close to $300 billion.

Losing control

Evidently, by June 2007, the RBI had given up the fine balance it had kept in the past between the rupee value and forex reserves as its core policy thrust and had clearly opted to back a cheaper rupee.

Consequently, the rupee — which was compelled to miss all the earlier chances to rise from 2004 to 2007 in order to help the RBI build huge forex reserves — missed what now seems as the best chance it had to catch up with the value it had sacrificed in the previous years. Had the RBI moderated the dollar purchases — that is, had it not bought as many billions of dollars as it did in the last seven months of 2007-08 – the dollar, which was globally lacking support even at much lower rates, would have fallen to less than Rs 35, perhaps even lower to Rs 32-33.

But in the last quarter of 2007, oil prices added another dimension. The world oil price rose to over $90 per barrel in October, crossed $100 in January 2008 and finally, leapt near to $150 in June-July 2008. A huge demand for dollars from oil companies in India ensued.

In the last quarter of 2007-08 both RBI and the Indian oil companies were buying dollars in spot and forward markets, hiking up the demand, and increasing each other’s costs! Immediately, the rupee began moving southwards. From a little over Rs 39 to a dollar in January 2008, the rupee moved down to almost Rs 43 to a green back by July 2008. Thereafter the G7-induced dollar rise of 16 per cent against the euro hit the rupee, and the RBI lost control. By October, the rupee is down to where it never had been — at almost 50 per dollar. Where did the RBI possibly go wrong?

First, under political pressure, the RBI seemed to have given up the fine balance between forex reserve building and rupee pricing in the last quarter of 2007. Second, given US economic sickness, the RBI never perhaps anticipated the re-rise of the dollar from August 2008. Third, the RBI was probably concerned about the oil price hitting the roof and therefore mopped up all available dollars as strategic reserves – a clear overreaction. Fourth, the RBI was probably overcautious.

Another possible scenario assuming that the RBI had maintained, as before June 2008, the balance between the forex reserve building and appropriate and stable rupee. In that case it would have moderated the dollar purchases to $2-3 billion a month for the whole of 2007-08, and bought some $25-30 billion during 2007-08 against over three times that number it had bought.

A third of what it had bought would have taken the forex funds to about $225-230 billion by March 2008. Had the RBI not bought the addition $60-70 billion, that would have added to the dollar glut in the global market and would have forced down the dollar value even globally and raised the rupee value to anywhere in the range of Rs 30-35 per dollar by March 2008.

The return of the dollar from about August would have certainly forced down the rupee again. But, granting that the rupee depreciated by as much as it has done now, namely by 17 per cent, the rupee would now be in the band of 35-41, or at worst a couple of rupees more, per dollar. It could not be as bad it is today with very little elbow room for further decline. The moral of the story: The RBI can only stop the rupee from rising against a globally falling dollar; it cannot stop the dollar when it rises globally for whatever reason, and prevent the fall of the rupee. The reason is basic. The dollar is a global reserve currency and has a global market.

The RBI cannot sell the dollar on the rise to bring down its value and raise the rupee value because the dollar will be sold, but the rupee will not rise. Will the RBI factor in this limitation in future? And will the advocates of a cheap rupee, and more importantly, the Finance Minister, rethink?

(Concluded)

(The author is a corporate adviser. guru@gurumurthy.net and blfeedback@thehindu.co.in)

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