The rupee's record-breaking slide against the dollar last week seriously tests the resolve of policymakers to defend the domestic currency in the face of an unholy combination of domestic and external factors. It is true that none of the factors pushing down the rupee is either new or unanticipated. Nor is India's predicament unique. Nearly all the currencies of other emerging markets have declined in dollar terms. While the government has identified the eurozone crisis and the increased outflow of foreign institutional investment as being the principal causes, one has to look at the shortcomings of its macroeconomic policies, especially those relating to the external economy in the context of an extremely uncertain global environment. Clearly a proximate cause such as the fast deteriorating eurozone crisis has had the potential to exacerbate one of India's well known structural rigidities, the dependence on volatile capital flows to bridge the current account deficit and support the balance of payments. The eurozone crisis has heightened risk aversion, leading to a flight of capital from countries such as India to safe havens. Many other emerging market economies have lost out but India, having an unacceptably high current account deficit, is particularly vulnerable. Again, the crisis in Europe has caused a dent in India's merchandise trade — the EU has been one of India's important export destinations. Moreover, European banks are among the largest providers of short-term debt to Indian companies. Obviously, their losses in Europe will have to be at least partially met by pulling out of India.

It is clear that a combination of interdependent factors is contributing to the rupee's decline. A multi-faceted problem does not admit of simplistic solutions. For instance, the suggestion to use the country's still sizeable-forex reserves to stem the decline is fraught with risks. The size of the reserves has been declining over the years. Experience in other countries suggests that reserves are best used to even out violent fluctuations in the exchange markets, seldom to defend the home currency over a long period. The government has announced a few austerity measures. While these are welcome, they are at best symbolic gestures. More effective measures should aim to check the trade and current account deficits. Unfortunately, many of the factors contributing to the widening deficits are beyond the control of the government. Oil prices are expected to remain sticky at the current high levels. The import bill is unlikely to come down in the foreseeable future. On the other side, exports have faltered after a heady run during most of last year. The rupee's fall is a symptom of a deeper economic malaise.

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