Managing the rupee | Business Standard Editorials

lipped from: https://www.business-standard.com/article/opinion/managing-the-rupee-122030901384_1.html

An orderly adjustment would be healthy

The US banned energy imports from Russia on Tuesday to apply more economic pressure as the war in Ukraine continues. While US import dependence on Russian energy is limited, it is a strong signal, and more allies could do the same. Large Western corporations in the energy sector are anyway moving out of Russia, which could permanently affect supplies and keep energy prices elevated in the foreseeable future even if a diplomatic solution is reached in the coming days and weeks. Since India is a large importer of crude oil and several other commodities, the macroeconomic complexities associated with higher commodity prices are thus likely to persist for some time. Oil prices have gone up by over 70 per cent since the beginning of the year. One of the ways in which higher commodity prices will affect India is through the external value of the rupee. Although the rupee has recovered some ground after slipping to an all-time low this week, the pressure is likely to continue, and it will need to settle at a lower level.

There are a number of reasons why the rupee will remain under pressure in the near term. Higher commodity prices will increase the demand for US dollars in the system, pushing up its price. Since higher oil prices have a significant impact on macroeconomic outcomes in India, foreign portfolio investors are moving out of Indian markets, which is adding to the dollar demand. Foreign investors, for instance, have sold Indian stocks worth over Rs 26,000 crore so far this month. Thus, there is pressure from both the current and capital accounts. More broadly, overall risk aversion in global markets means funds are flowing to the US, which has led to a decline in government bond yields, and is pushing up the dollar. Additionally, the Federal Reserve is expected to start increasing interest rates. Although the Fed is likely to be mindful of growth implications in the context of geopolitical tensions, rates would still go up, which will tighten financial conditions in the coming months. In fact, risk aversion started much before the Ukraine crisis as markets began to adjust to the possibility of higher than expected rate hikes by the Fed.

Thus, with the given global backdrop, it is clear that there will be pressure on the rupee. However, the Reserve Bank of India (RBI) would do well to not defend it despite large reserves, as has been argued by some. Reserves should only be used to contain undue volatility and not to defend the currency at any particular level. An orderly adjustment in currency would actually help stabilise the current account. A stable and manageable deficit on the current account would, in turn, make the currency more stable. But a weaker rupee will add to inflationary pressures. This does not mean that the RBI should not allow the rupee to depreciate. Inflation reduces the purchasing power and will be reflected in the external value of the currency as well. Obstructing this adjustment could create bigger imbalances. The RBI would thus need to reassess its inflation outlook and act accordingly. Its earlier projections for the next fiscal year are unlikely to hold, and it would now need to quicken the policy normalisation process. Ignoring inflation could increase risks, including external.

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