India is no longer the closed, simple economy of the 1970s. When the RBI attempts to fix the price of the rupee, it must contend with the incentives of millions of rational actors
)
Illustration: Binay Sinha
Listen to This Article
In the discourse on Indian economic policy, a recurring tension exists between the desire for administrative control and the requirements of a sophisticated market economy. This is currently visible in the exchange rate actions of the Reserve Bank of India (RBI).
For months, the RBI has engaged in a strenuous effort to prevent the depreciation of the rupee. In doing so, it appears willing to sacrifice the long-term project of financial sector development. This trade-off is problematic for two reasons: (i) it undermines the institutional foundations of the Indian economy, and (ii) every currency defence turns into interest rate hikes, which is not appropriate at the present moment for the economy.
What first needs to be recognised is that the exchange rate is overvalued. A real effective exchange rate of 100 is no longer an appropriate measure of the equilibrium exchange rate, as much has happened in recent years, especially the deceleration in exports and the withering of net capital inflows. To reestablish balance of payments equilibrium, the exchange rate needs to depreciate.
India is no longer the closed, simple economy of the 1970s, but a large, complex system with deep international linkages. When the RBI attempts to fix a price — the price of the rupee — it must contend with the incentives of millions of rational actors. In a sophisticated economy, the avenues for moving capital are numerous and varied.
When market participants perceive that the rupee is overvalued and that depreciation is likely, they respond rationally. Exporters choose to keep their revenues in foreign accounts for as long as possible. Importers hasten their purchases of foreign goods. Individuals and firms seek to diversify their portfolios by acquiring foreign assets or gold. These actions are logical risk-management responses by households and firms seeking to protect their net worth.
The scale of these private-sector responses is vast. The combined decisions of millions of participants dwarf the capacity of the RBI to intervene through administrative restrictions or the sale of reserves. When the RBI attempts to regain control by hitting at financial development — by restricting certain types of trades, closing market segments, or increasing the compliance burden on capital flows — it does not stop the underlying pressure on the currency. It merely forces that pressure into less transparent, less regulated channels while damaging the institutional capabilities of the formal financial sector.
To truly stop a currency from falling, the central bank must make holding that currency more attractive by raising interest rates. The RBI has ruled out interest rate increases for now. But this reticence cannot hold, because the “impossible trinity” mandates that a country with a fixed exchange rate and an open capital account cannot run an independent monetary policy. Ultimately, if the defence of the currency is sustained, interest rate hikes will need to follow.
However, the timing for such a policy in India is currently unfavourable. The economy faces headwinds. Aggregate demand is under pressure due to a slowdown in exports and a softening of remittance flows, a traditional pillar of support for the current account. Simultaneously, the bill for imported crude oil has gone up. In a standard inflation-targeting framework, these conditions — slowing growth and a negative terms-of-trade shock — would typically call for a supportive monetary policy, perhaps even a rate cut. Instead, the exigencies of the exchange rate defence are pushing the RBI in the opposite direction.
We have seen this movie before. On January 16, 1998, in the midst of the Asian Financial Crisis, the RBI raised interest rates by 200 basis points in a single day to defend the rupee. While the currency was momentarily stabilised, the shock to the real economy was severe. A similar episode occurred in 2013 during the “taper tantrum”. The RBI engaged then, as now, in a war on “speculators”. What began as an attempt to restrict financial markets rapidly morphed into an interest rate defence. The resulting spike in rates contributed to a slowdown in corporate investment and exacerbated a burgeoning corporate debt crisis.
Evidence suggests that these “fights with speculators” are rarely successful. An examination of emerging market responses to the 2013 crisis (https://shorturl.at/wFdyq) reveals a remarkable fact: India implemented more restrictive, interventionist measures that were detrimental to financial development than many of its peers. Yet, the rupee depreciated more than the currencies of many countries that maintained more open and market-consistent policies. The lesson is that administrative repression does not provide stability; it increases the risk premium associated with the country.
A floating exchange rate acts as a shock absorber. It allows the price of the currency to adjust to external shocks, such as changes in oil prices or global demand, without forcing the entire domestic economy to adjust through painful changes in interest rates or employment. Inflation targeting provides a nominal anchor, ensuring that the central bank remains focused on domestic price stability rather than being distracted by the impossible task of managing a specific exchange rate level.
It is, therefore, disappointing to observe the regression in RBI policy, which treats the financial sector as a set of taps that can be turned off and on at the whim of the regulator to achieve a short-term price target. This approach ignores the reality of how capable financial institutions emerge. Financial development requires decades of consistent, rule-of-law-based policies. It requires a climate where firms can operate with the confidence that the rules of the game will not be changed overnight. When the regulator periodically “breaks” the market to defend the exchange rate, it destroys the incentive for private firms to invest resources in their capabilities.
A central bank operating with frameworks not aligned with market realities is problematic for an aspiring global economic power. In this landscape, the Ministry of Finance must reclaim its role. It must recognise that damaging financial development and raising interest rates at the wrong point in the business cycle are detrimental to the long-term growth prospects of the country. As the ultimate custodian of the agenda for economic growth, it must look at the bigger picture.
The author is an honorary senior fellow at the Isaac Centre for Public Policy, and a former civil servant
aniltikotekar4sme.com 