The recent appreciation in the rupee was not entirely unexpected, given the significant improvement in India’s CAD in FY14 and the $34 billion capital inflows in lieu of RBI’s special swap schemes. Such a strengthening of the rupee was an obvious outcome, sooner or later. However, what is more important is, given the tectonic shifts in global finance, whether the appreciating trend of the rupee is sustainable. Equally important is RBI’s response in such a context.
In the past, prolonged easy monetary policies in advanced economies have changed the risk premia, resulting in significant switches in capital flows to emerging economies including India. Higher volatility in capital flows resulted in exchange rate volatility and generally had a profound impact on the spectrum of asset and commodity prices. As India has mostly financed its deficit in current account through surplus in the capital account, reversal in easy monetary policy in developed countries increased the pressure on currency and resulted in depletion of the forex reserve with RBI in the aftermath of the crisis.
India experienced large inflows of capital well in excess of its current financing needs (net of capital account and current account balance, as the accompanying chart shows) beginning FY03. For example, in case of India, such flows increased mani fold to an annual average of $47.4 billion during FY03-FY13, reaching a peak of $93.6 billion in FY08. Net capital inflows to India dried out in FY09 ($11 billion) to substantially lower than in FY08. But, in the subsequent years, capital inflow increased. In our case, though FY14 started with a weak economic sentiment with a high current account deficit (FY13 CAD $87.8 billion) and fiscal mismanagement burden, proactive measures to curb gold import has helped to do sufficient adjustment in the current account. In the current scenario, we expect in FY14, India would have a significant excess of foreign capital flow after paying its current account obligations. Thus, it is no wonder that the rupee is currently on the upswing.
What will be RBI’s response in such a scenario? Well, the first has to be to build up the foreign exchange reserves. Interestingly, India’s foreign exchange reserves had jumped by a cumulative $256 billion during FY03-FY08, with an $111 billion accretion in FY08 alone. Thus, it is not correct to say that there was no accretion. There was however a $58 billion draw-down in FY09 that was