Rupee breaches 81, policy challenge: let it find its value or burn forex, hike rates

As the rupee breached the 81-mark to the US dollar intra-day Friday, policy makers in New Delhi are in a dilemma with the Reserve Bank of India (RBI) having burnt forex reserves at a dramatic pace this calendar year to prevent exchange rate volatility – an intervention which many in the market believe is to defend the currency at a particular level.

In just eight months between mid-January and mid-September this year, forex reserves have depleted by almost $90 billion, or approximately an average of $11 billion a month. For the week-ended September 16, India’s forex reserves stood at $545.65 billion compared with $634.97 billion in the week-ended January 14.

“How long?” asked the CEO of a foreign institutional investor (FII), who did not wish to be named. While sustained high inflation of 7 per cent plus has prompted the RBI to hike policy rates, the government is keen to preserve GDP growth and create more jobs as several big states head for polls over the next 12-18 months.

With several agencies cutting the GDP growth forecast to 7 per cent and lower, the Union finance ministry is in a dilemma whether an aggressive tightening of the monetary policy is the appropriate strategy for India, which faces challenges that mayrequire a different response than the western countries. In this context, Finance Minister Nirmala Sitharaman has already said that “RBI may not be as much synchronised as the western countries would do” – in other words, hiking policy rates may not be the best thing for India.

Policy makers in the government as well as the RBI are convinced that a large part of inflation is “imported”. They are discussing relative advantages and disadvantages of an “overt” action such as an interest rate hike versus “covert” gradual depreciation of the rupee. “Unlike monetary tightening through rate hikes, which is akin to the use of a sledgehammer, letting the rupee find its level, is a better tool to rein in demand,” said an official, who did not wish to be named. A depreciating rupee makes imports more expensive, and curbs demand.

A depreciating rupee makes imports more expensive, and curbs demand.

According to RBI’s monetary policy report of April 2022, a 5 per cent depreciation in rupee could result in inflation edging up by 20 basis points while the GDP growth could be higher by 15 basis points. In 2022 so far, the rupee has depreciated by 8.2 per cent in 2022 against the US dollar. Policy makers in New Delhi seem to be veering around the view that the RBI should not hold any particular level sacrosanct. “This (gradual weakening of rupee) covert measure is better than an overt monetary policy action of hiking rates,” said a policy maker who did not wish to be named.

“Even today, the rupee closed above 81,” said a senior executive in an FII, pointing to the central bank’s aversion to let the rupee slip. The Indian rupee breached the 81-mark against the US dollar for the first time on Friday, before settling at 80.98, as the greenback continued to strengthen against all other major currencies following an aggressive rate hike announcement by the Federal Reserve.

In two days, since the Fed announcement Wednesday, the rupee has lost 1.5 per cent.

It opened at a record low of 81.03 against the US dollar, compared to the previous close of 80.86. The domestic currency fell to an intra-day low of 81.22 per US dollar. The weakness in rupee also dampened equity market investor sentiments and the benchmark Sensex at BSE fell sharply by 1020 points or 1.7 per cent to close at 58,098.9. The broader Nifty at NSE lost by 302.45 points or 1.7 on Friday to close at 17,327.3. Over the last two trading sessions the two indices have lost over 2.2 per cent.

The house is already divided over the quantum and pace of rate hikes by the RBI. There are early but discernible signs of a divergence of views between the government and the central bank on the latter’s monetary action to check inflation versus the former’s imperative to rekindle growth. The three-day RBI monetary policy committee is scheduled to begin September 28, with the action to be announced on September 30.

North Block is learnt to be leaning in favour of a benign pace of rate hikes by the RBI rather than the aggressive stand taken by central banks of developed countries since inflation is being seen driven mainly by global factors and other concerns about employment and sluggish investment taking precedence over inflation.