The currency level for any country in the market is quite ironically in the hands of the central bank today. This rather unique situation has arisen due to the ‘dollar story’. The dollar has been appreciating relentlessly against the euro, which is the starting point.

Consequently all currencies have borne the brunt and central banks everywhere have to decide how to counter this phenomenon.

Let us see why the dollar is getting stronger even while everyone talks of a recession in the US. The Fed has been increasing rates which are now at 3-3.25 per cent and are set to edge higher. The median projections for the Fed fund rates are 4.4 per cent in 2022 and 4.6 per cent in 2023. This means there will be more rate hikes.

It is possible to assume that the US is a strong economy, which makes the dollar more attractive. But as the rates increase, inflation gets tempered and activity slows down, there could well be a recession. However, higher rates also mean that the US is back to becoming attractive as an investment destination.

Now, other central banks are also increasing their rates with the Bank of England increasing them by 50 bps. The ECB may be next with another 75 bps. But the Fed will be ahead and the dollar will get stronger.

Theoretically, after a point of time when the recession sets in, the dollar should weaken and the euro should be back to the level of $1.05-1.10. But this is still some way off.

In such a situation what should the RBI do? If the RBI sits back and lets the rupee fall, rupee depreciation will become a self-fulfilling prophecy. The market will conclude that the RBI is okay with a level of 81 or 82 and probably push for 83 depending on the feelers that it is getting.

Exporters will hold back their earnings hoping to convert at a higher rate at a later date. Importers will rush in to buy future dollars to cover their imports.

Speculative risks

This will create a demand-supply gap and push down the rupee further. Speculators will also punt on the rupee in the non-deliverable forwards (NDF) market and widen the gap, thus accelerating the movement. Once this happens the rupee could be in free fall.

The central bank cannot allow this to happen. There are advantages surely in having a weak rupee. It supposedly gives a country a competitive advantage. But when the world is slowing down and the other currencies too are falling, this may not turn into an advantage.

Exports usually do well when the global economy is robust. A weak world economy is not beneficial for exports. On the other side, a weakening rupee without checks will lead to higher cost of imports. And as India has a large trade deficit with imports being higher than exports, this will result in imported inflation.

Higher inflation will become an issue for the central bank at MPC meetings. Therefore, the central bank doing nothing is not a good idea.

The RBI has so far been selling dollars in the market to stabilise the rupee. Hence, while the rupee has fallen, it has been better performing better than other currencies. Meanwhile, forex currency reserves have now fallen by $93 billion on a year-on-year basis and $55 billion since March 2022.

A part of this decline can be attributed to revaluation of reserves which happens automatically when the dollar strengthens and the euro, pound and yen (which are other minor components of our forex reserves) weaken. The RBI has also taken positions in the forwards market to drive sentiment. Evidently, the impact has been limited with the Fed factor dominating all movement of currencies.

Forex reserves

The question is: how much forex assets can the RBI keep supplying in the market to stabilise the rupee? The global reaction to the Fed is getting stronger. FPI flows are becoming volatile once again. August was a good month for us while the same cannot be said about September so far. The RBI has managed to control the rupee up to the ₹80/$ threshold. The market believed that the RBI would use reserves which had been built up in the past to defend the rupee.

But it should be remembered that all these reserves have come in not due to a current account surplus but capital flows, and cannot, or rather should not, ideally be used to protect a current account deficit which is also being driven by global factors.

The rupee has crossed the 80 mark and is now testing 82. It does appear that the RBI will now let the rupee slide a little more and probably would use other tools to intervene.

One way out is to go in for larger rate hikes. While these cannot match the Fed’s rate hikes, they will still send the signal that we are on the same page. Policy announcements are already in place such as getting in more ECBs, NRI deposits and FPIs. Those measures announced a couple of months back have not quite brought in funds and would take time to work under normal conditions.

As currency management gets interlinked with monetary management, the rupee movement cannot be left to the market. For the RBI there will be trade-offs. Forex management is now becoming an integral part of policy formulation as it affects not just inflation but also liquidity. Every time dollars are sold to banks, liquidity falls and it comes back to the door of the RBI; with liquidity now being tight, measures for inducing liquidity have to be part of the agenda. It is tough being a central banker in these times.

The writer is Chief Economist, Bank of Baroda. Views expressed are personal

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