On Monday, the financial markets continued to decline sharply from where they had left off on Friday. The rupee, under relentless pressure, fell below an exchange rate of 63 to the dollar, closing at yet another all-time low. Benchmark indices declined in tandem, while bond yields, reflecting the great uncertainty, zoomed. Gold prices have shot up as attempts to rein in demand ahead of the festival season failed miserably. This mayhem cannot be attributed to any one factor but clearly, recent rupee support measures have failed. Specifically, the Reserve Bank of India’s moves last week to restrict the scope of overseas investments by resident Indians and companies have not been received well. Although on closer examination the new rules are not as stringent as the financial markets make them out to be, the very idea of imposing restraints on any type of capital flows seemed to harp back to the days of foreign exchange rationing. It may not be a reversal of the liberalisation process as many have claimed, but the underlying fear that controls would be applied to inward flows as well, including those by foreign institutional investors has to be assuaged urgently. Even the Prime Minister’s assurance on this count has not been enough. Another aggravating factor has been the growing evidence of an economic recovery in the U.S. This has already caused capital invested in India and other emerging markets to flow back to the U.S. The prospect of the Federal Reserve’s ultra-soft monetary policy ending has already raised bond yields there.

Exaggerated or not, the financial markets’ sharp reactions ought to be seen as another instance of collateral damage in the wake of the rupee stabilising policies that began in mid-July. The inability of policy measures to check the fall of the rupee should prompt a debate on the costs of implementing them. The dilemma will then become obvious. If, for instance, the RBI’s moves to tighten liquidity and indirectly raise interest rates to check the rupee’s fall stays longer than intended, there is no doubt that growth will suffer. But growth will also be impacted if the rupee continues to weaken, inflation remains high, unhedged corporate balance sheets come under increased pressure and fiscal consolidation becomes even more challenging. The urgent task is to calm the markets. Clearly, for policymakers there are no easy options at the moment. Having chosen a particular line, it is best to stay on course lest the credibility of our monetary institutions is undermined. More effective communication will certainly help, as will the RBI and the government following the elementary rule of not speaking in discordant voices.

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