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The RBI's dilemma - Views on News from Equitymaster
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  • Aug 2, 2000

    The RBI's dilemma

    The RBI is in a fix. Earlier, it had surprised (or should we say shocked!) many by opting to raise rates to control the volatility in the forex markets. Now that the markets are once again witnessing volatility, the RBI has few options.

    Raising rates to quell the volatility in forex markets is a central bank's ace 'weapon'. Now that the Rupee is once again heading lower, it can only be anticipated that the RBI will once again raise rates. It may seem unlikely that the RBI will opt for a second rate hike in such a short span. But, in the first case too such a measure was widely unanticipated.

    There is however one other option. Leave the markets alone. And it is this option that the RBI must opt for. There are several reasons for this. First, depreciation in the value of the Rupee is not totally unwarranted. The high oil prices, large redemptions by FIIs, sharp rise in inflation (inflation based on the WPI is currently at 6% as compared to 2.8% in December) and the government's weak fiscal position warrant a correction in the value of the Rupee. Secondly, a weaker Rupee will go a long way in improving the competitiveness of Indian exports in international markets. The recovery in exports would benefit the domestic economy, which is still struggling to shake off the economic slowdown.

    Okay, depreciation in value of the Rupee would affect the country in terms of a higher import bill. Companies that have raised debt in the international markets too would be hit. And not to forget feedstock sourced from international markets would become costlier. However, a 5% depreciation in the value of the Rupee would not overburden us. Given that imports are approximately US$ 40 bn, a 5% impact would raise domestic inflation by 0.5%.

    The RBI maybe right in its justification that it is in favour of a controlled depreciation of the Rupee. But as in the earlier instance, there were other means to control volatility. Imposing higher interest rates has connotations for the investment economy, which, it must be mentioned, is still sluggish. The markets only hasten the process (admittedly they often overshoot) of price discovery. Their verdict is final (as seen in Southeast Asia and off late in case of the Euro) and is usually well informed.

    The RBI is in a dilemma. Its ace card has already been played and yet the other 'party' continues to gain in strength. Probably the RBI will see reason in market movements and take measures to control only the speculative activity. Blanket measures (like raising rates) hurt all sections, including speculators in forex markets (which form a very tiny part of the economy). Therefore it can only be suggested that the RBI limit itself to talking down speculation. Leave the rest to the markets. And if the depreciation still continues, let's remind ourselves that speculation also encompasses buying undervalued currencies!

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