If the rupee were falling ‘because of' a weak euro, it would not have fallen vis-à-vis the euro itself.  If on the other hand its fall were merely a mirror image of the rising dollar, it would fall about as much as the dollar rose.

But while the Fed's ‘broad' trade-weighted dollar index rose 5 per cent over the past three-and-a-half months, the rupee fell 14 per cent against the dollar. 

The period is too short to permit any inference about trends. But, generally speaking, it is worth bearing in mind that India has had a chronic current account deficit for years.

 Which is why, after decontrol, the rupee trended down from 1991 to 2002.

The trend did not, however, continue into 2003 and beyond, because of the increasing momentum of capital flows, mostly FDI and FII. Indeed, the RBI had to mop up foreign exchange in order to keep the rupee from appreciating.

 To some extent this was even otherwise required, in order to build up reserves.

But the inflows were much larger than required for prudence alone. And so, while continuing to welcome inflows, the RBI opened the doors to current and capital account outflows (such as personal remittances and travel, and outbound FDI); despite which reserves are still in the vicinity of $300 billion (given the current account deficit, liabilities are naturally much higher).

In perpetual deficit

 Be that as it may, with the current account perpetually in deficit, the ups and downs of the rupee after 2003 largely mirrored the pace and direction of capital flows. This was most visible during 2007-08 (when the rupee rose sharply despite the RBI buying up $29 billion) and from June 2008 to March 2009 (when the rupee tumbled despite the RBI selling $39 billion).

In a nutshell, so long as the current account is in deficit, the natural tendency of the rupee is to fall. Whether and how much it falls depends on the pace and direction of capital flows, and on RBI intervention.  

It has been suggested that since the present fall of the rupee is likely to be temporary, the RBI should do exactly what it has been doing: nothing.

It is hard to agree. If the fall is expected to be temporary, timely RBI intervention would avoid needless frictional costs on the real economy. That is the whole purpose of ‘containing volatility'. On the other hand, if we have a trend on our hands, which is unlikely, there is really nothing that can be done about it.

Inflows slowing

 According to the Prime Minister's Economic Advisory Council, the current account deficit for 2011-12 is expected to touch $55 billion. Though FDI/FII inflows for April-September 2011, at $20 billion, are not too far off the mark, there has been a disturbingly sharp deceleration between the first and second quarters, from a monthly average of $5.4 billion to $1.4 billion.

One last thing. The RBI did not in fact do ‘nothing'. After following a strictly hands-off policy for almost a year, it sold $845 million this September. The amount is not large, but might be intended to serve as a signal to investors and speculators that the RBI will step in if required.

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