Floating on the rupee

The rupee has depreciated sharply in the last one week. We are fortunate that unlike countries in the eurozone like Greece and Italy, which do not have the advantage of a flexible currency, we have one of the most important mechanisms of macroeconomic adjustment working in our favour. However, the adjustment can happen only if accompanied by other supporting policy changes.

The recent fall of the rupee has been unexpected. Yet, as the dollar gets stronger against other currencies, this is not surprising. As the eurozone crisis worsens, and as the Italian debt problem deepens, the dollar may see a further strengthening due to a flight to safety. Domestic Indian conditions — particularly the high inflation rate, the rising current account deficit and the weakening investment climate — have further added to the pressure on the rupee.

A major concern about the weakening of the rupee is that it will lead to an increase in prices of imported goods. However, if the fall of the rupee is to be restricted to a one-time move in prices, rather than persistent inflation, India would need to have a central bank with a clear mandate of price stability that could peg inflationary expectations. Monetary policy would need to move away from conflicting objectives and be credible and consistent in its commitment to control prices. It would need to move away from rate hikes in an ad-hoc manner to a new framework of accountability and communication. This could help prevent the depreciation from resulting in persistently high inflation.

If the exchange rate appreciates when the economy is booming, and depreciates when it needs a boost in demand, it provides a stabilisation mechanism for the economy. Macroeconomic stabilisation policies like fiscal and monetary policy are often constrained by political pressures, as in India and the eurozone. If the currency of a country can move freely, it can provide one of the most important sources of adjustment for the economy. While countries in southern Europe are trapped in the euro, a currency that cannot adjust according to the needs of the economy, despite large current account deficits, India has the advantage of a currency that can help stabilise the current account deficit as well as boost demand for domestic products. By making imports more expensive and exports more competitive, a weaker rupee can help floundering demand.

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