There was a marked lack of knee-jerk reactions in the financial markets this week as the rupee sank to its lifetime low of 69 to a dollar. Though the slide was triggered by global cues reminiscent of the taper tantrum episode in May 2013, the depreciation has been far more orderly this time round. The rupee has slipped by 7.4 per cent against the dollar over the last six months compared to the free fall (21 per cent depreciation) it witnessed in May to August 2013. Multiple factors have contributed to the recent depreciation. Tighter oil supplies, geopolitical tensions and US sanctions on Iran have sent global crude oil prices soaring, bloating India’s dollar demand. At the same time, rising US interest rates, a shrinking Fed balance sheet and a strong dollar have seen foreign funds pull out $6.7 billion from Indian markets in 2018, forcing a dollar shortage.

The financial markets appear to be taking comfort from the fact that India’s macroeconomic fundamentals today are in far better shape to handle external shocks, than they were in 2013. Despite the rising import bill, the country is expected to run up a current account deficit (CAD) of 2.5 per cent of GDP in FY19, far lower than the 4.8 per cent in FY13. Recent CPI inflation readings have stayed below 5 per cent, offering comfort that low food prices may cushion the impact from spiralling oil. Thanks to its stockpiling of dollars over the last two years, the RBI’s foreign currency reserves, at $385 billion, provide import cover for nearly 10 months compared to barely seven months in FY13. But policy-makers cannot afford to relax their vigilance. The fundamental indicators cited above can deteriorate very quickly indeed, in the event of a run on the currency. A sliding rupee can set off a vicious cycle on the CAD and inflation numbers. Foreign portfolio investors (FPIs) are known to react in a knee-jerk fashion to dwindling dollar returns. The RBI has tried to pre-empt such outflows by raising the FPI ceiling for bonds and relaxing its residual maturity conditions. But then, India’s FPI flows in the last couple of years have featured a lot of hot money chasing rate differentials, and the RBI will face a rapid drawdown of its coffers if it tries to counteract an exodus.

This makes it imperative for the RBI to keep the powder dry on its dollar reserves, without expending them too early to defend the exchange rate. For some time now, the rupee has been significantly over-valued on a REER (Real Effective Exchange Rate) basis relative to its trade partners, blunting the competitive edge of domestic exporters. A pass-through of rising oil prices to Indian consumers may also have the desirable side-effect of curbing consumption. Given the circumstances, it is best that the RBI allows an orderly correction of the exchange rate, stepping in with market interventions only if it needs to fend off speculative volatility.