Rupee tantrums: The risk and cost of RBI’s approach
The excessive exchange-rate stability of the past two years may have come at huge cost to the economy. For two years the rupee was stable. So stable that the International Monetary Fund reclassified India’s exchange-rate regime to ‘stabilised arrangement’ from ‘floating’ in December 2022.
The tide turned in October 2024, and the rupee has lost 3% of its value against the dollar since then. The Reserve Bank of India (RBI) aggressively intervened in the forex markets, spending some $70 billion from its reserves to defend the rupee, but couldn’t break the fall.
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The rupee broke through the barrier of 85 against the dollar on 23 December. Reports suggesting that the RBI may be less inclined to persist with its tight control over the exchange rate under new governor Sanjay Malhotra added downward pressure in forex markets, sending the rupee to a new low of 86.63 against the dollar on Tuesday. Some forecasts suggest it’ll breach 90 this year.
The markets are jittery, unsure of the level at which the rupee will settle and how quickly it will get there. By some estimates the rupee is overvalued by about 8% in real terms. If so, it has some catching up to do. The pace of this correction will be tempered by the political appetite and the risk of financial instability.
A long time coming
As such, there has long been a case for the rupee to fall. Former governors said in closed-door meetings that fighting fundamentals would prove futile. But the RBI remained adamant and kept insisting that it was only suppressing volatility. Data reported in ET shows the rupee became one of the most tightly managed currencies.
The new governor may have to re-evaluate this costly approach. The RBI may have lost $220 billion from its reserves in defending the rupee over the past two years, former chief economic advisor Arvind Subramanian has estimated.
But that’s not the only cost to the economy.
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When forex users such as importers and borrowers in international markets see the RBI intervene too much, they get a message about how the exchange rate could be expected to move. Over the past two years, they saw the rupee being propped up. Now they are seeing it weaken, and the bets they took are going awry. The RBI still has $640 billion in reserves, so why isn’t it arresting the slide, they complain.
The RBI estimated in December that a third of all external borrowings were unhedged for currency risk. Risk management was effectively outsourced to the RBI by the borrowers, who may now find their loans becoming more expensive due to the rupee’s slide.
Forex users stop hedging currency exposure when they see the rupee defying fundamentals, and then, when the central bank lets go or can no longer control the exchange rate, as is happening now, this unhedged exposure catches them wrongfooted. Since the RBI has never defined volatility, it’s difficult for them to second-guess how it will now manage the exchange rate.
The outcome of all this is that the rupee’s stability over a period of just two years is at risk of becoming a cause of financial instability in the medium term.
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