Strong Dollar Will Make it More Difficult for RBI to Defend Rupee, Says Ex Gov Subbarao

The RBI’s stated policy is that it does not target any specific exchange rate but manages only excess volatility in the exchange rate. In other words, it’s not RBI’s intention to prevent the movement of the rupee consistent with economic fundamentals. It only tries to ensure that the trajectory of movement is smooth.

RBI intervenes in the forex (foreign exchange) market by buying or selling dollars to smooth excess volatility. For example, if the rupee is depreciating steeply, RBI sells dollars to smooth the movement. After all, the reason we hold reserves is to use them for preventing excess volatility.

For sure, there is a cost to holding reserves but the benefit is the stability it gives to the exchange rate. The challenge for the RBI is to ensure that the cost benefit calculus is net positive.

That said, what is ‘volatility’ and what is ‘excess volatility’ in the RBI’s stated policy are not explicitly defined. Any intervention can technically be justified as being consistent with policy. This ‘inexactness’ puts additional burden on the RBI to demonstrate that it is walking the talk.

For about two years, the Reserve Bank maintained a relatively stable rupee by selling dollars from its foreign exchange reserves. However, as you pointed out, the rupee has depreciated significantly over the past two months. This shift suggests that the RBI is now allowing the currency to find its market determined level.

I believe the current policy of letting the rupee find its level is appropriate, especially since the rupee is overvalued in real terms. The strong rupee has hurt India’s export competitiveness, which, in turn, has affected overall economic growth.

Note also that inflation has reduced the domestic price of the rupee. It’s only appropriate therefore that the external price of the rupee too falls to correct this imbalance.

Of course, a depreciating rupee is inflationary. But if we take the overall impact of a lower rupee on growth and inflation, the net impact should be positive.

Yes, though I’d frame it more as certainty than uncertainty. The dollar is likely to remain strong for an extended period due to Trump’s domestic and external policies. Additionally, the Federal Reserve is unlikely to cut interest rates which will reinforce the strength of the dollar.

A strong dollar over an extended period will make it even more difficult for the RBI to defend an overvalued rupee. Given this context, the RBI’s current approach of allowing the rupee to find its market determined level seems appropriate.

I cannot speak for the RBI. However, as I said, the stated policy of the RBI is not to target a specific exchange rate. This means there is no officially defined threshold beyond which the RBI will shift its policy stance.

While I wouldn’t speculate on specific numbers, it’s clear that there is an inherent tension between the RBI’s simultaneous mandates of controlling inflation and maintaining currency stability. A depreciating rupee adds to inflationary pressure which complicates this balance. The RBI must carefully weigh its inflation control objectives against the need to manage exchange rate stability.

Both theory and experience tell us that the exchange rate is not the sole determinant of export competitiveness. In fact, a weak rupee gives us only a temporary advantage. Sustainable competitive advantage comes from improved productivity which in turn is a function of factors like the efficiency of our manufacturing processes, quality of infrastructure, cost-effectiveness and the skill endowment of the labour force. Improving productivity is where our focus should be.

Some economists argue that India’s export demand is more a function of income than of price. In other words, what matters for our export performance is more global growth than the price of the rupee. But that is no argument for keeping the rupee overvalued against fundamentals.

I am disinclined to comment on the RBI’s policy stance. But objectively, the RBI faces a policy challenge in balancing across its several objectives of reducing inflation, supporting growth and maintaining financial stability including a stable exchange rate. These goals are interconnected, and any decision will depend on how the RBI weighs the trade-offs between them.

Our ability to achieve the $5 trillion GDP (gross domestic product) target—and how quickly we get there—will be influenced by multiple factors, including the exchange rate. Geopolitical conditions, global economic prospects and international trade dynamics will also play a critical role.