Mumbai: In its biggest single-day gain in 21 months, the rupee surged 75 paise, or 1.02 per cent, against the greenback Tuesday to breach the psychological 73-a-dollar mark, ending the day at 72.87-a-dollar as compared to its previous close of 73.62.
Why did the rupee gain 1% Tuesday?
While the gains come after a strong run in August, with the domestic unit performing as the second-best currency in Asia, the Tuesday surge can be attributed to what is being seen as the Reserve Bank of India (RBI) opting for a hands-off approach by allowing the currency to strengthen, apart from healthy inflows and a weak dollar.
The central bank, in its statement Monday, announced measures to cool down yields on sovereign bonds, saying, “The recent appreciation of the rupee is working towards containing imported inflationary pressures.”
This marked a shift from its earlier approach and pushed the rupee immediately.
What is RBI’s forex rate management policy?
The central bank doesn’t disclose its foreign exchange management strategy, but it was evident in the last few years that the rupee was not allowed to appreciate despite healthy inflows, resulting in a rapid build-up of foreign exchange.
From a low of $275 billion in September of 2013, when rupee came under severe pressure due to so-called ‘taper tantrums’ by the US Federal Reserve, India now has record foreign exchange reserves of $537 billion, as on 21 August — a 95 per cent rise over seven years.
Despite the Covid-19 pandemic, the foreign exchange kitty swelled by $62 billion since March.
In this seven-year period, rupee ended the year with an appreciation against the dollar only once — in 2017. In the last two years, the rupee ended weaker by 8.45 per cent in 2018 and 2.26 per cent in 2019. This year, the rupee is so far down by 2.04 per cent against the dollar.
What is the change that was made to this policy?
The latest RBI statement suggested that it is not uncomfortable with the appreciation in rupee, confirming the speculation among currency analysts that a departure was made in the exchange management policy.
In other words, going forward the central bank may not intervene in the foreign exchange market aggressively to mop up the dollar and slow the domestic unit’s pace of gain.
“The sharp drop in USD/INR since 24 August has spurred discussions over whether the RBI is turning less aggressive in its accumulation of FX reserves,” Nomura said in a note to its clients.
“We believe there are factors that could have spurred a change in the RBI’s approach, including the level of reserves and adequacy, a desire to mitigate inflation, the liquidity impact of unsterilized foreign exchange interventions, the prospect of smoother inflows and potential INR [rupee] undervaluation,” the note said.
What forced the shift?
The recent trend in consumer price index-based inflation, which has stayed above the mandate of 6 per cent for two consecutive quarters as well as the first month of the third quarter, has worried the central bank.
The central bank is answerable to Parliament if it misses the inflation target — 4 per cent with an upper and lower tolerance band of 2 per cent — for three consecutive quarters.
Currently, with the policymakers facing the challenge of supporting growth, which is expected to be negative in 2020-21, the central bank won’t be able to hike interest rates to contain inflation.
So, the central bank is now acknowledging that it can at least control imported inflation by allowing rupee to appreciate.
As long as inflation stays elevated and growth fragile, the changed currency management stance could be expected to stay.
Why this change could result in slower forex reserves growth
Since the rapid rise in foreign exchange reserves over the last few years was mainly due to aggressive intervention by the central bank, the latest move could also result in a slow build-up of foreign exchange reserves.
The central bank could draw comfort from the fact that its reserve adequacy is nearly three times the requirement and is one of the highest among other Asian economies.