There is something puzzling about how the government appears to be thinking about policies relating to capital inflows and the rupee. On the one hand, it is going all out to attract more foreign capital inflows and is also encouraging overseas borrowing by Indian companies. On the other hand, it now appears undecided about whether or not to allow further significant appreciation of the rupee against the dollar, a highly likely outcome if net capital inflows continue to surge.
It is hard to fathom that April's uncharacteristically huge appreciation of the rupee against the dollar was solely the RBI's decision. It is equally hard to imagine that the central bank's return to intervention in the foreign exchange market in recent weeks is without the government's sign-off, or perhaps the intervention is at the government's suggestion.
The fact of the matter is that the RBI is not an independent central bank and the extent of its intervention in the foreign exchange market has to be viewed as part of the broader public policy about capital inflows, the cost of sterilising the RBI's intervention and the politically palatable pace of rupee appreciation. Effectively, the central bank has to work within the markers and constraints set by government policy and goals.
Capital inflows on their own are generally unlikely to have political repercussions. But significant rupee appreciation can turn into a political liability if it is beyond the threshold of what businesses can live with.
After the hands-off approach in April toward the rupee, the RBI is back to intervening in the foreign exchange market, and the government has also announced "relief" measures for some export sectors. Undoubtedly, exporters need to further improve productivity, over and above what they have done in recent years.
But the government has to take into account the political liability of the hit to, say, employment from substantial rupee appreciation in some export sectors. This is no different from other unwanted baggage that the government carries, but the decision to carry it or not is more political than economic. But surely there is a limit to how many such packages it should offer.
Perhaps there was a strategy behind the April move: allow the rupee to appreciate substantially, and then it will partly retrace its "overshooting" as market expectations will be revised to anticipate depreciation. However, when the appreciation pressure did not abate after the big-bang rupee move in April, it is possible that the RBI was called in to either fight or manage a quick break below the 40 level.
If the above was indeed part of the gameplan behind the April move in the rupee, it has obviously failed, as it should have for two reasons: (1) the magnitude of rupee's appreciation in April was perhaps not large enough; and (2) apart from structural factors, the rupee is also impacted by cyclical capital flows, which will likely continue to exert further appreciation pressure.
There is no way to accurately gauge a priori how much appreciation will be needed. Thus, the April move was really an experiment: allow the rupee to appreciate significantly and hope that that does the trick. However, if it doesn't, then one should be prepared for another sizable move, if it is political feasible.
But a substantial appreciation within a short time has political repercussions, as the government is now finding out. It is possible that the April strategy could have worked if the government was willing to swallow rupee appreciation to 35 or so. But is that experiment politically palatable? I doubt it.
Actually, the April move has been counter-productive, as it has further cemented expectations for more rupee appreciation and exposed a chink in the policy armor. The only reason the rupee has not broken the 40-level against the dollar is because of the RBI's intervention, not because investors think that the rupee has overshot.
Indeed, investors generally remain bullish on rupee's medium-term prospects. Tactical market positioning and shifts in risk appetite will influence the near-term prospects for the rupee, but they won't alter the structural factors behind the rupee's strength.
Left on its own, the rupee will appreciate as long as net capital inflows are strong, as is likely to be the case. Given the anticipated strength of capital inflows, the RBI will only have to be called in to intervene at successively lower levels.
Basically, the push to attract more foreign capital appears to be taking place without giving much thought about how much the economy can absorb without creating challenges for monetary policy, and about the approximate level where the exchange rate becomes a political liability.
In recent years, easy global liquidity conditions and an increased risk appetite have amplified capital inflows into India, a large portion of which would have come in attracted by expectations of the sustainability of India's economic rise.
But the key issue about capital inflows and the rupee has to be charted as part of the broader policy: the government needs to better appreciate that it cannot, on a sustained basis, encourage excessive capital inflows and also resist significant rupee appreciation.
A sustainable solution is for the government to significantly step up the pace of reforms, including infrastructure, which will boost productivity and, in turn, justify further real exchange rate appreciation. But progress on that front remains frustratingly slow, uneven and uncertain.
Given that, if we are going to encourage significant capital inflows, then we need to let go more of the rupee. If the exchange rate is approaching - or is already beyond - the threshold of political comfort, then, at least in the near-term, we need to recalibrate our single-minded approach toward boosting capital inflows as if nothing else matters. But it is preferable to avoid the current policy hodgepodge.
It is not surprising that with inflation becoming less of a concern, the RBI is back to intervening in the foreign exchange market. But it is fighting with one arm and one leg tied: the government wants to encourage more capital inflows, but now doesn't want too much rupee appreciation, and also doesn't want to foot a higher bill for sterilisation securities.
The recent inflation scare caught the Congress party off-guard and reportedly contributed to its poor showing in the state legislative elections. The SEZ policy also came back to haunt the government. Now, badly managed dynamics of capital inflows and the rupee could unexpectedly backfire at a wrong time to become a costly political mistake in the run-up to the next general election. Congress political strategists beware.
The author is executive director at JPMorgan Chase Bank, Singapore. The views are personal
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