When rational people see this one-way bet, they would sell assets. First, it may be FIIs who are already selling rupee assets in order to return money to their investors. A temporary “good price” for the rupee would encourage them to sell while the rupee is still strong and before it weakens further. Next, it will be Indian residents who would prefer to liquidate their investments in India and move rupees into dollars before the rupee weakens further. Containing rupee volatility in these times would set off asset sales in India by both foreigners and Indians, who would try to sell assets now in order to take money out the country at a favourable exchange rate. By trying to reduce volatility, the RBI would trigger a financial crisis.

Moreover, today the intervention in the rupee market may be through the sale of dollars. Tomorrow, as the dollars start fast disappearing, the logical next step would an interest rate defence of the rupee. Once a central bank gets into a gamble like this, concerns about fighting speculators tend to take prominence, and the needs of the economy are not kept in mind. An interest rate hike would be like the action taken on January 16, 1998, when in the midst of the Asian crisis and a sharp business cycle downturn, the RBI tried to defend the rupee by raising interest rates by 200 basis points on a single day. With an impending slowdown this could do huge damage to the economy. Independence of monetary policy requires exchange rate flexibility. The RBI should make monetary policy decisions while only thinking of domestic business cycle conditions, without a conflict of interest stemming from currency objectives.

... contd.