The rupee finds itself under pressure again, retracing the gains made earlier this year. Fears arise about further weakening and, understandably, calls go out for the Reserve Bank of India (RBI) to use its reserves to support the value of the rupee. In this environment, RBI must confront the paradox of foreign exchange reserves in deciding how to handle currency policy.
Foreign exchange reserves provide an indispensable signal of strength backing a country?s currency. But unlike other expensive deterrent forces a country underwrites for national security, such as the military, foreign exchange reserves are ephemeral, vanishing as they are utilised. Hence, the more a country defends itself with foreign exchange reserves, the weaker its defences appear. Perhaps for this reason, reserves rarely succeed in defending against anything other than temporary depreciation pressures. The frustrating paradox of reserves is their simultaneous necessity and futility.
One of many ways RBI Governor Subbarao has distinguished himself from his predecessors has been his approach to currency management. He has only intervened to dampen market volatility, not to attempt to influence the overall rate. To be fair, pressure on the rupee during YV Reddy?s tenure was almost exclusively to strengthen, and the paradox of foreign exchange reserves does not apply to appreciation. Stemming persistent appreciation implies accumulating reserves?easier to manage than spending them?making it much more tempting to oppose the market.
While the advantages may be difficult to appreciate as the market moves, Subbarao?s policy of allowing greater rupee flexibility provides many benefits to India. In particular, exchange rate movements act as a valuable macroeconomic adjustment mechanism. Through exports and imports, appreciation helps cool the economy when it overheats, and depreciation boosts the economy when it lags. Exchange rate movement also sends a signal to policymakers about whether macroeconomic management is aiming in the right direction. Further, allowing the currency to move up and down forces the private sector to bear the cost of hedging foreign exchange risk, which discourages unhealthy imbalances in cross-border lending.
When considering using reserves, RBI must also consider future needs. Some worry that Indian reserves already look insufficient to bolster the currency, given that the amount has roughly held steady for the past five years while the economy has continued to grow. Gauging the adequate amount of reserves has become trickier since the global financial crisis.
Previously, economists worried mostly about needing reserves for domestically-generated problems or for contagion from other emerging markets. For those purposes, the best simple benchmark is covering all short-term debt and the current account deficit, representing a full year of external payments coverage. The most current debt data for India that includes long-term debt with less than a year to maturity is from June 2011, and measures to encourage NRI deposits will probably have raised short-term debt levels since then. Nonetheless, reserves will likely remain at roughly 40-50% above this benchmark. By this metric, India could burn through almost $100 billion and still appear robust.
The experience of the global financial crisis suggests simple benchmarks miss a much more complex reality. Among other aspects, countries compete against each other for investments, so peer behaviour matters. Holding double the benchmark looks great unless everyone else holds triple. In this case, Chinese currency policy that led to $3 trillion in reserves continues to distort markets by setting an unhealthy standard. It is unrealistic and undesirable for India to build such unassailable reserves, yet investors will inevitably compare.
When capital markets fell apart from September 2008 to March 2009, the rupee fell 18% with a modest amount of RBI intervention. That was almost matched by the rupee decline in the final four months of 2011 when there was no comparable external crisis. But economic fundamentals looked much more robust in 2008 than today. Potential GDP growth was assumed to be just below 9%, fiscal and monetary policy had ample room for expansionary policy, and the current account deficit amounted to less than 2% of GDP.
Current rupee weakness largely emanates from home-grown factors that don?t appear temporary. That is why the $20 billion of reserves RBI burned through last year accomplished nothing. Given today?s economic backdrop, another shock to global financial markets might require much heavier use of India?s reserves. With Europe still struggling to contain its crisis, foreign exchange reserves should be used judiciously.
The potential risk of an external shock piling onto domestic problems should instead provoke a more concerted effort to repair the economy. Here RBI is apparently as frustrated by lack of progress as everyone else. Using reserves to prevent further rupee decline would only provide temporary respite to those who are avoiding meaningful reforms. Better to continue RBI?s policy of minimising disruptive volatility, but allowing the market?s basic message of dissatisfaction with the pace of reform to ring out loud and clear.
The author is the Will Clayton Fellow in International Economics at Rice University?s Baker Institute for Public Policy. He was earlier based in New Delhi as the US Treasury Attach? for India
