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The rupee has taken a severe beating in the past few months, depreciating by more than 12 per cent since the start of 2013-14. The depreciation intensified because FIIs withdrew from Indian debt markets, following market expectations of the Fed tapering its QE programme.
In the context of a depreciating currency, monetary tightening is the standard textbook prescription, rather than the best option. The best option is guided by an assessment of the macro economic situation.
The current Indian economic scenario is grim. Both, factory output and exports fell by 1.6 per cent and 4.5 per cent, respectively, in May 2013. There was a slight uptick in WPI inflation for June 2013 at 4.9 per cent, compared with 4.7 per cent in May 2013. Inflation based on consumer prices was placed at 9.87 per cent for June 2013 compared to 9.31 per cent in May 2013. The economy is clearly dealing with stagflationary tendencies.
Monetary policy can help only to an extent. The major support for the rupee has to come from responsible fiscal management and investor-friendly policies. The RBI works towards the overall goal of growth with stability.
A predictable exchange rate is essential for a stable external sector. Given the currency volatility in recent months, the central bank was only expected to act. The recent measures of the RBI are aimed at discouraging imports and improving the attractiveness of rupee denominated debts by making funds costlier. However, the experience in the last three years does not lend much support to this argument.
Major imports like oil and gold are price inelastic. FII flows seem to be governed more by growth prospects than interest rate differential. Sustainable servicing of debts at higher interest rates is possible only if higher growth takes place.
The tight monetary stance will ultimately be reflected in hardening of interest rates. Earnings of companies will come under further stress, and that can trigger withdrawal of FII flows from the equity segment, exacerbating rupee depreciation. Investment banks have already revised their growth projections for 2012-13 by a few basis points, following the RBI’s announcement.
Unless growth gets compensatory support from fiscal policy, the situation would worsen. The element of surprise in RBI’s latest move to hike the marginal standing facility would help contain the fall in the rupee in the short run. However, it is unlikely to give a major upward push to the rupee, given the inelastic demand for dollars arising from oil and gold imports. In a supply-constrained economy, promoting growth through supportive monetary and responsible fiscal policy may be the best way to support the rupee.
(The author is Economics Professor, Xavier Institute of Management, Bhubaneswar.)
Read also: Is tight money the best way to deal with falling Re? - Yes
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