Why the Reserve Bank of India (RBI) has not tried to prevent the recent rise of the rupee even though it now seems overvalued in real terms?
The rupee touched its highest level against the US dollar in 17 months recently.
The Indian currency has rallied against the greenback since the beginning of this year.
So have many other emerging market currencies despite the increases in interest rates by the US Federal Reserve.
India has also in recent months seen strong capital inflows that have been in excess of what it required to fund a modest current account deficit. These capital inflows have pushed up the value of the domestic currency.
Policy conundrum
There is an important policy conundrum here. The Reserve Bank of India (RBI) has not tried to prevent the recent rise of the rupee even though it now seems overvalued in real terms. The real effective exchange rate against a basket of 36 other currencies was 118.38 in February—one of the highest levels in many years. Even though Indian exports have recovered in the past few months, it is sobering to remember that currency overvaluation has most often led to higher current account imbalances in the medium term.
Why RBI has not intervened?
Many wonder why the Indian central bank has not intervened to keep the rupee down even though it seems overvalued by its own metric. One possible reason could be the excess liquidity that is currently sloshing around in the Indian financial system.
The demonetisation announced in early November forced citizens to park their currency holdings with banks.
The restrictions on withdrawals meant that the composition of broad money changed dramatically as demand deposits substituted currency in portfolios.
Banks remained wary of lending the money pouring into deposits because they were not sure of how long this money would remain with them.
The central bank did try to mop up some of the excess liquidity with the banks through the issue of market stabilization bonds. Yet there is no doubt that there is still too much liquidity at a time when the monetary policy outlook has moved from accommodative to neutral.
Any aggressive buying of dollars by the RBI at this juncture will only add to the excess liquidity that is already so evident in the money market.
It is thus likely that the Indian central bank has stayed away from foreign exchange intervention because it does not want to further exacerbate the excess liquidity problem, because it will have to release rupees into the market whenever it buys dollars. Sterilization firepower is limited right now, which is precisely why it had to issue market stabilization bonds in the first place.
Market Stabilization scheme (MSS) is a monetary policy intervention by the RBI to withdraw excess liquidity (or money supply) by selling government securities in the economy. The MSS was introduced in April 2004. Main thing about MSS is that it is used to withdraw excess liquidity or money from the system by selling government bonds.
The RBI will also have to take into account the fact that loose money market conditions could eventually feed into inflation. Getting the balance right will thus be important.
The question is whether this is a temporary issue that will go away once people begin to withdraw money from their banks or when bank lending picks up. But there can be no doubt that the excess liquidity sloshing in the system right now could be one important reason why the RBI has not been intervening more aggressively in the foreign exchange market to keep the rupee down.
