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Rupee and RBI: A Match not Made in Heaven

Published 22-06-2022, 06:43 pm

We all have been hearing about Rupee depreciation against the dollar of late. At USDINR of about 78.06, Rupee has depreciated by more than 5% in the last year. But, rupee depreciation is not something unheard of. Since 1991, INR has consistently depreciated against the dollar.

Since 1991, we have adopted the Liberalised Exchange Rate Management System (LERMS), the floating exchange rate system. In such a system, RBI frequently intervenes to manage the currency by buying or selling foreign currencies in the open market. This is done to ensure stability to the country's Balance of Payment (record of all monetary payments between a country and other nations during a particular time period). 

While rupee depreciation against the dollar is widely known, what most of us don't know is that INR has strengthened against EUR by 7% in the last 12 months. 

But why do we really bother about EUR or any other currency so much compared to USD?

The answer is RBI's 40-country Real Effective Exchange Rate (REER). It is RBI’s metric to measure Rupee's relative competitive strength and EUR features in the top position in India’s trade-based weight and only marginally second after USD in the export-based weight. 

What is REER?

Before we come to REER, let us first understand what is NEER. Hold on, we know we are only confusing you but just spare us a minute!

Nominal Effective Exchange Rate or NEER is an index of the weighted average of bilateral exchange rates of home currency vis-à-vis currencies of trading partners. The weights are derived from their shares in the trade basket of the home currency. So, if India trades with the only US and Europe, NEER will be the weighted average of INR/USD and INR/EUR with weights depending upon the proportion of trade with both the countries. 

REER is nothing but NEER adjusted for inflation differential between the home economy and its trading partners. 

Without going too much into the actual computation of REER, simply put, it is an effective exchange rate that assesses the fair value of a currency or the external competitiveness of an economy vis-à-vis its trading partners. It serves as a guide for the monetary and financial policy strategy of the central bank. 

India's REER is based on a currency basket of 40 countries which reflects the country's key foreign trade partners. 

As of May 2022, India's REER was 115.3, compared to 113.7 in April and an all-time high of 118.3 in Nov 2017. FYI, an increase in REER indicates reduced competitiveness for the economy, which is not good. 

RBI's role in currency management

RBI has always categorically stated that they do not target any specific level of Rupee and only intervene when there is excessive volatility. However, RBI has often NOT let the market find its level. Case in point is during the pandemic period.

During FY 2021, India saw a surge in foreign money pouring into the country. This resulted in a big swing in current account balance (the sum of net goods and services trade and remittances) from a deficit of $25 bn in FY20 to a surplus of $24 bn in FY21. Total net flows including FDI (foreign direct investment) as well as the FPI (foreign portfolio investment), had reached its all-time high of $107 bn. RBI consciously lapped up massive USD in the open markets to prevent the Rupee from appreciating below 72.0

Had it not intervened, a sharp appreciation in Rupee would have hit investors with a foreign exchange exposure, including those considering investments into India. It would have also hit exports and made imports cheaper, further damaging domestic manufacturers during pandemic times. So, it looks like RBI did the right thing.

Now what?

Currently, we are in a completely opposite situation. We are now seeing huge foreign exchange outflows. Our FY23 Current Account Deficit (CAD) could be around $100 bn. Amidst persistent geopolitical tensions and supply chain problems, we see no major reverse of these flows anytime soon. So, should RBI now do the opposite and use its coffers to sell USD to arrest the fall in Rupee now?

We do not think RBI will intervene too much to use its forex reserves to tackle depreciation as it may lead to external instability. Even though RBI has ample foreign exchange reserves of around $600 bn, translating to around 20% of the GDP but any fall below 15% ( to $450bn) could create panic. 

Thus, RBI may let INR weaken gently. Why is that so? To correct INR overvaluation in terms of REER and kind of prepare for possible stress scenarios by way of improved domestic economy and higher exports (helped by weak Rupee). This could well mean USDINR weakening further or even crossing 80.
One more reason why RBI may not intervene much is that rupee depreciation attracts a lot of FIIs both via FDI and FPI routes. Historically, every rupee depreciation cycle was followed by a stock market rally. Thus, RBI might let Indian Rupee stabilize on its own without too much intervention for a change. 

This policy does sound very ad-hoc, and we cannot agree more. It is high time that we considered putting together a comprehensive policy for currency management, aligned with the monetary policy to be better prepared in such adverse times. 

Disclaimer: The above analysis is just for informational purposes.

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