The sale of dollars will also mean more rupees being sucked out of the system. Monetary policy will then have to scramble in sterilising this intervention, given how tight liquidity conditions already are. For the last seven years we have seen how monetary policy got hijacked by the RBI’s exchange rate policy. In this, it was a case of preventing appreciation. The RBI would buy dollars, then sterilise its intervention, then raise rates to prevent inflation, only to find that this further attracted inflows. In the process it lurched from one mess to the other. Before we get into a similar though reverse kind of mess, the best policy is to step away from rupee manipulation and to let it float.

One reason why the RBI was able to continue to try to prevent rupee appreciation in recent years was the fact that there is no physical limit on the reserves it could go on piling. However, on the reverse side there is a limit and, given the desperate global demand for dollars, this limit of zero reserves can be reached.

But what about inflation? Some observers argue that the RBI should intervene in the market to prevent the rupee from depreciating further as a weak rupee is inflationary. It is true that a strong rupee can reduce the pressure on prices. However, keeping the rupee strong for a few days, which is all that the intervention can achieve, is not going to do much to prices. Moreover, the impact of the exchange rate pass-through will be felt after a lag. During this time some part of it will be offset by lower global commodity prices owing to the declining demand in the world today. A decline in GDP growth is expected; this would put downward pressure on prices. Finally, in a time of global financial crisis, inflation concerns have to take the back seat. Financial stability and adequate liquidity should be the RBI’s prime concern.

... contd.