India's new RBI governor Sanjay Malhotra will have to make tough choices in managing the rupee exchange rate. Should he focus on controlling its ups and downs like the previous governor did? Or should he focus on adjusting the value of the rupee to keep pace with the rising dollar? It's a tough decision that will shape the country's financial stability.
Former RBI Governor Shri Shaktikanta Das had made great efforts to keep the Indian currency stable. He ensured that foreign investors as well as local importers and exporters could gauge how the rupee would behave.
Now that the leadership has changed, there is speculation about whether the Reserve Bank of India will change its exchange rate policy. Some critics say that Das's tight controls have kept the rupee too closely pegged to the dollar. This has affected India's export competitiveness at a time of sluggish economic growth.
The new RBI governor, Sanjay Malhotra, has not expressed his views on rupee policy. However, there may be a chance that he will allow the currency to move more freely. The rupee hit its highest level in more than a year in December, as the dollar continued to strengthen.
Abhay Gupta who is a strategist at Bank of America Corp. in Singapore said, "Before the new governor of RBI, the strength of the dollar and unpredictable capital flows were already building the pressure. A more strategic approach was needed to manage the Indian currency and the change in leadership might have just provided the perfect reason to make that shift."
Former Chief Economic Adviser Arvind Subramanian has suggested that the RBI should return to a more flexible exchange rate. In newspapers and articles, Subramanian and others have argued that imposing tight controls on the rupee would hurt India's export competitiveness. They have also pointed to side effects including tight monetary conditions and the risk of speculative attacks on the currency.
The inflation rate of the rupee has adjusted for trade competitiveness with the effective exchange rate hitting a record high of 108.14 in November. This suggests that the rupee may be overvalued by 8%.
"The rupee needs to depreciate by 2-3% on average to come into line with its long-term real value", said Kanika Pasricha, chief economic adviser at Union Bank of India. The rupee was nearing 86 after hitting several lows in recent days. This is due to the increasing pressure from a strong dollar and a widening trade deficit on the Indian currency.
"India's external accounts have moved from comfort to caution mainly because foreign direct investment has slowed sharply. This could be due to lower cash inflows or sending money abroad", said Namrata Mittal, chief economist at SBI Mutual Fund. The RBI's foreign exchange reserves, which hit a record $705 billion in September, fell to an eight-month low of $640 billion on December 27. The decline began around the time Donald Trump won the presidential election. By November, the RBI's futures portfolio had fallen by about $60 billion. That meant the bank had to buy the matching amount and settle the maturing contracts or tap into its reserves further. "No matter how much you hold, if you lose so much of your reserves in a short period of time, it doesn't send a good signal to the market", said former RBI deputy governor Viral Acharya.
Meanwhile, MUFG Bank Ltd. has revised down its rupee forecast. It now expects the rupee to weaken to 86 from 88.50 by December. "The RBI's FX policy may ease back from heavy intervention that allows the rupee to weaken, but it is unlikely to allow the rupee to fall completely", chief currency strategist Michael Wan wrote in a note.
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