The Indian Rupee (INR) has been under the vigilant watch of the Reserve Bank of India (RBI), which has focused on maintaining stability and reducing volatility. Although this strategy is effective in the short term, it has its complications and potential consequences in the long term.
The Reserve Bank of India’s steadfast commitment to maintaining the stability of the Indian rupee has been the cornerstone of its monetary policy. By limiting the impact of external factors such as portfolio flows and changes in economic expectations, the RBI has succeeded in keeping the Indian rupee ratio under control. This low-volatility environment helps improve the currency carry profile, allowing interest rate spreads to be reduced and reducing the need to hedge foreign exchange risks, although the cost of doing so is lower.
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However, this long period of low volatility can hinder market price discovery and create a backlog in hedging demand when the volatility regime eventually changes. Moreover, the RBI’s strategy of building foreign exchange reserves by absorbing capital inflows may lead to a gradual depreciation of the Indian rupee over time.
The continued low volatility in the Indian Rupee is a direct result of the Reserve Bank of India’s efforts to maintain stability. By containing rising currency fluctuations, the RBI aims to decouple monetary policy decisions from external influences. This policy has succeeded in keeping portfolio flows to India largely unhedged, despite historically low hedging costs.
But this stability comes with a set of challenges. The Reserve Bank of India may have exaggerated its efforts to control volatility, pushing it to levels similar to those experienced by a dollar-pegged currency. Low volatility for a prolonged period may hamper price discovery for the Indian rupee and create pent-up demand for hedging. Moreover, the gradual shift in the trading range has made it difficult for the market to capture significant interest rate hikes, as a lack of correlation with macro fundamentals remains.
One of the consistent policies followed by the Reserve Bank of India has been the aggressive accumulation of foreign exchange reserves. This strategy aims to create a buffer zone against future capital outflows. While the Reserve Bank of India has been defending the Indian rupee rate against weakness, the risks of a policy shift are increasing. The need to unwind short futures positions that have built up as the INR defends around the 83.5/USD level could increase the risk skew towards a gradual decline, making the USD/INR more vulnerable to a buy-the-dip strategy.
To understand the RBI’s patterns of intervention, an analysis of key factors over the past decade reveals that the RBI’s highest sensitivity is to portfolio flows, with inflows to reserves absorbed at a ratio of approximately one to one. This consistent correlation with portfolio flows is partly due to the broader relationship between US dollar movements and portfolio flows to emerging markets.
Another consideration is the competitiveness of the Indian rupee, especially in promoting domestic manufacturing and import substitution. Recent fluctuations in the trade balance, driven by rising oil prices and widening deficits, have shown a higher correlation with the strength of the US dollar. The Indian Rupee’s Real Effective Exchange Rate (REER) index has remained within a range over the past decade, although it is currently approaching the upper end of this range. While long-term real exchange rate appreciation can be justified by productivity gains, further appreciation may be undesirable from a policy perspective.
The Reserve Bank of India’s careful management of the rupee has helped maintain stability, but it also brings challenges. As the RBI continues to build its foreign exchange reserves and grapples with the complexities of keeping volatility low, the possibility of a gradual depreciation of the rupee remains a key consideration. This balance will be crucial in shaping the future of monetary policy in India and the trajectory of the rupee in the global market.
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X (formerly Twitter) – Aayush Khanna