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As rupee weakens, RBI should avoid mistakes of the past decade

The RBI has suddenly found itself fighting a war, a seemingly unwinnable one at that, against two national enemies—inflation and a weakening rupee.

Published: 20th May 2022 06:59 AM  |   Last Updated: 20th May 2022 06:59 AM   |  A+A-

A guard at RBI office

The Reserve Bank of India. (File photo | PTI)

The RBI has suddenly found itself fighting a war, a seemingly unwinnable one at that, against two national enemies—inflation and a weakening rupee. In a battle, it’s all about the first punch, which the central bank did launch by raising policy rates and selling dollars. Sadly though, both solutions are unlikely to address the root problem. While the former helps anchor inflationary expectations and not price rise itself, the latter won’t arrest the rupee’s rout, but can only smoothen out market volatility, which is also the RBI’s stated position. The Indian currency has been witnessing a steady decline in line with emerging market currencies, and lost about 4% against the dollar since the start of 2022. It may be noted that a 5% depreciation of the rupee from its baseline assumption would add 20 bps to inflation, which is already troublesome enough. 

The outlook for rupee is being weighed down by rising interest rates, strengthening of the greenback and the anticipated higher current account deficit, which is likely to hit a 10-year high of 3% of GDP this fiscal. On the bright side though, currency depreciation eases current account pressures by curbing imports and boosting exports. Some also believe the rupee is overvalued, and hence the RBI should allow it to find its own level. A few private estimates peg the rupee to touch 80 in the near term, while over the long run, it could go past 90 by FY29, as per the IMF.

A weakening currency can test the nerves of policymakers, even when RBI has built sizeable precautionary forex reserves, which fell from $640 billion last October to about $595 billion now, to fend off any pressure on the rupee. But experience from the past isn’t as encouraging. During the 2013 taper tantrum when the US Federal Reserve decided to withdraw surplus liquidity, the rupee fell 15% in just three months flat. This was despite having sufficient stock of reserves. While the central bank did start out with good intentions, building buffers then and even now, it should avoid repeating the mistakes of the past decade.



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