The fall in the external value of the rupee in relation to the dollar has been overshadowed by the calamitous events in the international financial markets. The central banks and governments around the world have been focussing exclusively on the unfolding financial sector crisis originating from the United States. Although it is more than a year since the sub-prime crisis surfaced, it assumed menacing proportions only recently, as seen in the spectacular failures of iconic financial institutions in the U.S., prompting monetary authorities to resort to some bold, unconventional measures to save some of them. The fast-paced developments in the U.S. and other developed markets have important negative consequences for the emerging financial markets such as India’s. The extreme loss of investor confidence, coupled with serious disruptions in the international money markets, has caused a flight of capital from emerging markets in search of safety. Indian stock market indices, along with those of most Asian markets, declined sharply, although they recovered subsequently. Ironically, the dollar, though the currency of a country whose financial sector is in deep crisis, has emerged stronger than many other currencies of the developed world. In India, where the exchange rate is primarily determined by demand and supply, the outflow of portfolio capital naturally aggravated the rupee’s fall. Given that a year ago, an appreciating rupee raised important issues such as export competitiveness, its accelerated decline has major implications for the macroeconomy.

The Reserve Bank of India has done well to announce a package of measures aimed at increasing the supply of dollars and augmenting liquidity. Promising to intervene aggressively in the domestic markets, the central bank has raised the interest cap on the FCNR and NRE deposits. The RBI’s ability to intervene has not been hampered but it would be naïve to ignore the dwindling of the foreign exchange reserves by about $21 billion since April this year. The financial sector crisis has underscored the virtues of India’s prudent exchange rate and other external sector policies. The measured steps towards capital account convertibility have most certainly kept a check on capital flight in these troubled times. It is important that the rupee’s sharply depreciating trend is arrested quickly because it can spur capital outflows as investors anticipate further declines. In conjunction with a widening current account deficit and falling asset prices, it can have serious consequences for macroeconomic stability.