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Trying to defend the rupee by selling dollars is a losing proposition

The Reserve Bank of India’s foreign exchange reserves declined by $2.676 billion to stand at $593.279 billion in the week ended 13 May. The weekly data shows that the fall was mainly on account of a drop in foreign currency assets (FCA), a major component of the overall reserves, and a fall in its gold reserves.

FCAs declined by $1.302 billion to $529.554 billion in the week. Gold reserves decreased by $1.169 billion to $40.57 billion.

The RBI’s data also shows that in March, its forex reserves dropped by $20 billion on a net basis on rising dollar sales by it in the spot markets — the highest ever in a month.

The RBI’s reserves have been on a declining trend. In the previous week, they had declined by $1.774 billion to $595.954 billion. Just months ago, in September, they were at the all-time high of $642 billion. Reserves were down to 10 months of export cover as of 6 May, not a risky level but the pace of erosion is alarming.

While part of the loss is because some of the non-dollar currencies held as reserves have lost value against the strengthening dollar that is rallying against most currencies, the RBI has also been intervening in the foreign exchange market, spending dollars from its reserves, to defend the rupee which is falling non-stop, and will continue to do so, even if the RBI tries to control the slide to protect the rupee.

The rupee that slumped to an all-time low of 77.80 to a dollar last week has been diving to newer lows every few days over the past few weeks, as global capital is shifting away from emerging market economies such as India to the relative safety of the US financial system after the US Federal Reserve started increasing interest rates and reversing its loose monetary policies. Narrowing of the interest rate differential between the US and emerging markets such as India will only hasten the pullout of dollar investors.

In these inescapable circumstances, why is the RBI spending so much forex so urgently? Fighting rupee depreciation by dipping into its reserves aggressively is a losing battle; the RBI should let the rupee depreciate smoothly.

Given that rupee depreciation is inevitable in these circumstances, the RBI should stick to its stated objective of ensuring that there isn’t undue volatility in the currency markets. It should smoothen currency movements. Trying to defend the rupee by selling dollars is a losing proposition when the dollar is set to strengthen, not just against the rupee but most other currencies, as it has been, for some time.

Second, speculative currency trade is well-aware of New Delhi’s ideological intolerance for ‘rupee weakening’ and its proclivity for seeing the foreign exchange rate as a measure of ‘national strength’.

In fact, armed with this information, speculators had hammered the rupee in the 2018 episode of its fast-paced depreciation. The RBI had roughly spent around $25 billion from its $425 billion stockpiles of reserves between April and September 2018. Yet, the rupee had gone from about 65 to a dollar to more than 71 to a dollar at the same time. The RBI intervened thereafter very selectively, probably recognizing the futility of resisting the slide.

The RBI’s reserves were smaller then. Similarly, in the 2013 episode of the ‘taper tantrum’, when too the US Fed’s indication that it would wind down its massive quantitative easing policies sooner than expected, had led to an outflow of dollar investments from emerging markets such as India, resulting in a run on the rupee. And the RBI’s efforts to defend the rupee that was dipping to new lows amid speculative trading had plunged the reserves to below $275 billion.

While the rupee has plunged deeper than in 2018 and 2013 in this latest bout currently playing out, the relatively bigger size of the reserves is a source of comfort. However, the Fed’s rate increase cycle has just begun and is likely to carry on well into 2023 if not 2024. Therefore, the RBI runs the risk of getting caught in a position where it has spent too much from its reserves too soon, by trying to slow the rupee’s slide. It should instead focus on smoothening the volatility.

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