Allowing the rupee to strengthen can help contain the creeping inflation – The Hindu BusinessLine

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With the consumer price inflation at 6.9 per cent in July, the RBI needs to exercise caution over increasing the supply of rupees as a fallout of its foreign exchange management

The sudden spurt of volatility witnessed in the Indian currency market in the last week of August drives home the truth that it is not possible to control market forces endlessly. The Reserve Bank of India had been trying to rein in rupee appreciation over the last five months, but the currency gained almost 5 per cent in this period. This was due to a host of factors, including strong foreign portfolio flows, declining crude oil prices, increase in external commercial borrowing, and the weakness in the dollar. The rally until August was, however, gradual. The sudden sharp spike of almost 2 per cent in just a few sessions in August indicates that the Central bank is going slow with its dollar purchases and is willing to let the rupee appreciate a little. Over the last five months, the Central bank had followed the strategy of buying dollars to bolster its forex reserves as well as to contain rupee appreciation. It has net-purchased $67 billion between March and June this year, as a result of which forex reserves currently stand at $537 billion.

But the Central bank appears to have stopped intervening in the foreign exchange market of late, owing to a few reasons. One, with a sufficiently robust forex kitty at its disposal, for use in the event of a financial market contagion, the RBI can now afford to rest a little easy. Two, with global central banks, including the Federal Reserve, vowing to keep infusing money into their economies to contain the negative impact of the pandemic, external threat to the currency appears lower. The third factor that is likely to have influenced the Central bank is the impact of dollar buying on domestic inflation. With the consumer price inflation at 6.9 per cent in July, the RBI needs to exercise caution over increasing the supply of rupees as a fallout of its foreign exchange management. In the prevailing context, it may not be a bad idea for the Central bank to stop trying to keep the rupee weak and instead allow it to find its market-determined value. The positive effect of a stronger rupee on bringing down import-induced inflation and improving the trade deficit needs to be borne in mind.

Meanwhile, the RBI also needs to review the allocation of assets held as foreign exchange reserves. Almost 92 per cent of the reserves are held as foreign currency assets (excluding gold and SDR), which are predominantly parked in dollar-denominated securities. The income from forex assets is expected to have slipped in recent years due to declining interest rates in the US and other countries. A more proactive and dynamic management of these assets would be desirable. The portion of forex reserves held as gold, which is under 7 per cent, can be raised to reduce concentration risk.

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