Why efforts to fight rupee depreciation are futile

Barking up the wrong tree

The impact of inflation on the value of a currency has two sides. One side is the reduction in the domestic purchasing power of the rupee. The other side is the fall in the external value of the rupee, which is known as depreciation. It raises the cost of essential imports, aggravating the inflationary pressures further.

Following the hopeful signs in May 2021 of global economic recovery from the effects of the Covid-19 pandemic, restrictive measures, including lockdowns, came to be relaxed. The revival in the aggregate demand was promptly reflected in crude oil price. International crude price rose from $69/barrel in May 2021 to $79 in September 2021. After some volatility, the price rise seemed unstoppable from January 2022 onwards. From $92/barrel then, it shot up to $108 in April. It touched $114/barrel in May.

Retail inflation, measured on the basis of consumer price index (CPI), has been rising since mid-June 2021. India imports 85 per cent of its petroleum crude requirements, which amount to 25 per cent of its total imports. Transport costs stemming from the rise in retail prices of diesel and petrol are a major component in the pricing of goods from farms to factories and from raw materials to finished goods. Retail inflation hit a high at 6 per cent in January 2022, which is the upper limit within which the Reserve Bank of India (RBI) seeks to contain it: the mandate is to keep inflation at 4 per cent, with a 2 per cent margin.

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The monthly inflation data, say, of March, is known only in the second half of the following month, April. Hence, given that the bi-monthly meetings of the interest rate-setting Monetary Policy Committee (MPC) of the RBI are held in the first week of the month (April, June, August, October, December, February), the policy indicator rate is decided based on old data.

The MPC, in its meeting on April 6-8, decided its policy on the basis of February inflation, namely 6.10 per cent, since March CPI data was unavailable till April 12. As the RBI then sensed only a slight breach in the targeted comfort zone of inflation, it preferred to maintain status quo on the interest rate at 4 per cent.

But it was shocked when March inflation data was released on April 12. It was much higher, 7 per cent. Had the MPC met a week later in April, the decision would have been different. The lesson is obvious: the MPC should consider scheduling its bimonthly meeting in the third week of the month.

Be that as it may. An emergency meeting of the MPC was convened on May 4 and it did what it was expected to begin doing to control aggregate demand to curb inflation. It raised the repurchase rate (repo), at which the central bank lends against bonds from the commercial banks to inject further liquidity into the system, making it costlier for banks to borrow, and therefore to lend to their customers. The repo was raised by 40 basis points (bps) to 4.40 per cent. The cash reserve ratio (CRR), the mandatory cash that banks have to park with the central bank, was also raised by 50bps. The factors causing the steady rise in retail inflation for the past seven months were no longer considered “transitory”, but to be longer lasting. They were attributed to “global commodity prices touching historic highs, pick-up in core (fuel and food) inflation, revision in electricity tariffs, and the continuing war in Europe.” It looks certain the MPC meeting on June 6-8 will raise the repo rate, perhaps by 60bps to 5 per cent.

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The other front

In the context of rupee depreciation following domestic inflation and increases in interest rates by the advanced economies, the RBI has to open another front to arrest the fall in exchange rate. A great deal of hesitancy and a pleasing approach of “extraordinary accommodation” have dented the RBI’s image of autonomy. Short-term foreign portfolio investors have been pulling out funds as in their perception, India is not “a safe haven”. As macroeconomic indicators deteriorated, the hot money flowed out as investors were rattled by rising exchange rate risks. Further, imports have become expensive, causing trade deficits, reflected in the monthly declines in foreign exchange reserves (forex).

From a record $642 billion in September 2021, the forex level is shrinking. The RBI’s latest upward revision of repo rate to 4.40 per cent has failed to stop capital outflows. The forex level is now $593 billion. The exchange rate, as of May 24, was Rs 77.52 per dollar. Towards arresting a further fall in the rupee, the RBI has been intervening in the market, selling dollars for rupees to make the dollar cheaper relative to the rupee.

Though there are upsides to currency depreciation in the long term -- such as (i) exports would pick up, (ii) tourists would rush to India, and (iii) it would make India attractive for foreigners to invest in IPOs -- the downsides in the short-run weigh more. The cost of imports would rise up faster. The response of the export sector would not be quick enough. One immediate negative effect is that the rupee depreciation will add to inflation.

Limits to intervention

The current forex level is equivalent to 10 months of imports. There are limits to what the RBI can do by intervening on the rupee. Instead, immediate fiscal measures are needed.

They must include measures from reducing taxes on inputs to lowering the costs of production, such as the recent reduction in cess on petrol and diesel. There would be loss of revenue, but they will result in early gains. Retail inflation will likely fall, though the impact will be known only in mid-July when June CPI data is released. In the meantime, the government should curb its own consumption.

(The writer is Adjunct Professor, Amrita School of Business, Bengaluru Campus)