Amidst the turmoil in the stock markets, one might choose to underrate or even ignore the significance of the sudden volatility in India's foreign exchange markets. That would be unfortunate. The rupee's steep fall against the dollar, after a fairly long period of stability, is a development that has major implications not just for exporters and importers but for the macroeconomy. The sharp declines in both the stock markets and in the rupee's external value, interrelated as they are, have some common features. With the global economy pushed to the brink by the persisting sovereign debt crisis in the euro zone countries, the uncertainty in the global financial markets increased as a natural consequence. Last week, there was a huge sell-off in the stock markets around the world, including India. At the global level, there is a strong demand for dollars as a safe haven. Ironically, all the troubles the United States is facing — a sharply lower-than-expected economic growth, persistently high unemployment, and fractious politics — have not dimmed the lustre of the American currency. Heightened risk-aversion, which is a direct consequence of the global crisis, has caused investors to liquidate their assets in what they perceive to be riskier markets and repatriate the money to safer destinations. Consequently, the demand for the dollar from exiting foreign institutional investors has risen in India, pushing up its price. In times of great uncertainty as now, it is not the prospect of better return but safety that drives investment decisions.
On Monday, the rupee traded around Rs.49.60 to the dollar, perilously close to the psychologically important Rs.50 mark. In the current phase of rupee depreciation, the RBI does not appear to have intervened aggressively, possibly because it wants to conserve its firepower for a future contingency. The foreign currency reserves at around $318 billion may be comfortable, but not sufficient for a long-drawn campaign of intervention. Besides, the negative sentiment is driven entirely by global factors over which the RBI has no control. Also, the growing dependence on short-term flows and the widening current account deficit might neutralise the impact of intervention. As a rule, a depreciating rupee is good for exporters. But this time, the swing is so sudden and sharp that the exporters were, probably, caught off-guard. In any case, many of them would have hedged their positions. These explain why there has not been an adequate supply of dollars in the domestic market. But the truth is that exporters, like importers, prefer stability in exchange rates. The chances are that exchange rate management will be more challenging in the days to come.
