The rupee has depreciated sharply in the last one month. In the coming days it is likely that the pressure on the rupee to depreciate will remain high. Should the rupee be allowed to find its own level or should the RBI intervene to prevent rupee depreciation? Should the possibility of importing inflation, when inflation is already a matter of concern, mean that the RBI should sell dollars to prevent the rupee from weakening further? I argue below that this would be a bad idea. The RBI should not sell its dollar reserves. The safest path is to let the rupee float, and to take steps to strengthen the currency futures market.

The rupee moved from Rs 44 at the end of August to beyond Rs 48 last week. Whether the RBI intervened to prevent rupee depreciation or not is not known yet since intervention data has a two-month lag. Some media reports and foreign exchange reserves figures suggest that the RBI may have intervened to defend that rupee. If the RBI did intervene last week, then the policy needs to change now as the global crisis has worsened sharply.

There is a consensus amongst economists that a central bank must not come in the way of a fundamental adjustment of the exchange rate. However, many people think that it is better for a central bank to “reduce volatility”. Suppose the exchange rate had to move from Rs 45 per dollar to Rs 49 per dollar, and suppose the RBI tried to spread this change of 10 paisa per day over a period of two months. In this period, the market would face a one-way bet where the rupee is expected to depreciate.

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