The Reserve Bank of India’s selective control in the forex market has been unable to control the free fall in the value of rupee in the recent months. This raises a fundamental question as to whether the RBI should consider alternative exchange rate policy options.

Specifically, would moving towards a completely fixed or floating exchange rate regime offer immediate help to the country?

Currently, by following a mid-path — that is, by selectively controlling foreign capital movement and partially regulating exchange rate prices — the RBI does not seem to successfully combine the best of both regimes.

So what are the feasible options available outside of the one we currently follow?

Value of a currency

The value of currency, like the price of any other good or service, depends on its demand and supply. And demand for a currency, say, the US dollar, typically comes from Indian importers, people or institutions that invest in the US (FDI or FII outflows) and travellers to the US. All these agents require dollars for transacting in the US.

Analogously, exporters to the US, travellers to India, FDI and FII inflows supply US dollars in return for rupees to transact in India. If the demand for the rupee decreases compared to, say, the US dollar, the value of the rupee goes down, and vice-versa. How does the central bank ensure that a parity, say for instance, one rupee equals 0.25 US dollar, is maintained? The answer lies in how it moderates demand and supply of local and foreign currency.

To explain, assume that the demand for US dollar increases. Consequently, its value increases, such that each dollar can now buy 10 rupees instead of four previously. To offset such an increase, the RBI pumps in sufficient amount of dollars into the market to meet the increased demand. This process ensures that the value of the dollar is restored to its original one. The central bank can supply and draw dollars from forex reserves, which is its official kitty.

Indian scenario

Currently, the RBI controls foreign money flowing in and out of the country through different routes. At the same time, it selectively engages in buying and selling of foreign currencies to mediate demand and supply in the forex market.

In effect, the RBI regulates the forex market intermittently.

But its ammunition to defend the value of the rupee at any particular level is not sustainable for several reasons. First, India’s forex reserves, which stand at $260 billion approximately, cannot defend the falling rupee eternally. Even worse, much of the reserves are liabilities than assets, implying that our ownership in reserves is that much lower to help moderate currency demand and supply.

To explain, let us assume that one bad day, all foreign investors (FDI and FII holders) in our country decide to take back their money (which is extremely unlikely). In that dire situation, the RBI would have to borrow to a tune of $215 million to pay them all back.

Also, the increasing oil imports and falling export share in the recent months have contributed significantly towards draining (the already concerning levels of) our forex reserves. The arguments above indicate that the RBI does not have sufficient cushion to adhere to a fixed rate regime.

What is the way out?

Proponents of the RBI’s current (midway) policy argue that if the rupee is completely let free to the market, it would worsen the import bill (particularly through our oil imports) and might potentially deter economic growth.

There are potentially few weak links in the claim above. First, such an argument is purely based on the assumption that if the rupee is completely left to market forces, then its value would only depreciate, which does not “have” to be the case.

But even such a scenario provides a good scope for domestic industries to invest on import substitutive industries. Also, this sets the stage for harnessing the abundant natural energy sources such as solar, wind, and thermal power domestically instead of depending on imported oil. We also need to bear in mind that the RBI’s selective intervention in the currency market feeds into the heavy subsidy in crude oil prices. This combination hurts our economy in several ways.

To explain, if the entire price increase in crude oil was allowed to pass through (with no subsidy) to consumers, they would have, perhaps, used the commodity more efficiently. If this was combined with a “floating” exchange rate system, the rupee’s value would have deteriorated even further, and the pinch would have been felt all the more. This would have only made us more efficient in using oil.

Also, our fiscal deficits in this case would not have soared to the current concerning levels owing to huge subsidies.

Moreover, monetary policy tends to be more effective under coordinated efforts from fiscal discipline — and fiscal discipline becomes an unachievable objective, with the level of subsidies that our government currently provides in the oil and fertiliser sectors.

So arguments against letting the rupee’s value to be determined by market forces do not seem to factor in the structural positive changes from which the country could benefit from.

Of course, if the RBI lets the value of rupee to be entirely market-determined, and eases out current restrictions on capital flows, there would be temporary displeasures from several corners. Particularly, those who have to repay in US dollars would have to bite the bullet if the market-determined value of the rupee turns out to be much lower than the current levels (and vice-versa).

However, the trade-off is pretty healthy in the long run, for the reasons mentioned above.

Under these circumstances, we might want to ask ourselves the following question: Who knows better about the price of a good — government or the buyers and sellers?