Opinion: Policy prescriptions for a falling rupee

The rupee seems to be in free fall, having breached the 60 Rs/$ barrier for the first time recently. Current account deficit for the last fiscal year 2012-2013 was a startling 4.8%, nearly double the RBI's 'safe' deficit level of 2.5%. I believe it's important to separate the jingoistic nationalism from the real policy prescriptions. We need to remind ourselves why a depreciated rupee is necessarily a bad thing.

Let me invoke the simple, static IS-LM framework for this elucidation. India is probably at a point like Y today - we are below our true economic potential (Y*) and have a Balance of Payments deficit*.

One of the 3 lines - LM, IS or BB (balanced BoP) - lines has to move to restore equilibrium. Based on this, one can come up with the following policy prescriptions to end the slide of the rupee.

(1) Monetary Contraction: One of the easiest ways to stop the rupee's slide would be for the RBI to raise interest rates. An undesirable result of this would be lower output levels. At a time when economic growth has already stumped to a very low level, there would not be many buyers for this policy prescription. However, hear me out. In its effort to save the rupee by selling dollars, the RBI is already reducing its monetary base (i.e. high-powered currency consisting of its foreign and domestic assets). In any case, this will lead to monetary tightening and higher interest rates - thus leading to lower output.

(2) Fiscal Expansion: An even more undesirable way of stopping the rupee's slide would be for the Government to start a fiscal expansion. Not only will it tend to appreciate the rupee (by raising domestic interest rates), but it will also increase output and take the economy out of the slump. However, we are unlikely to find many buyers for this option either. The fiscal deficit is already at a high level; any attempt to increase it further is likely to be resisted highly and also damage investor confidence (which shifts the BB curve to the left - hence increasing the deficit). A Government living well beyond its means has therefore closed this option.

(3) Currency Depreciation: I wonder why there is necessarily a problem to let the rupee depreciate. Over time, the J-curve effect takes place and the current account deficit will be cured - our imports will reduce, and exports will increase. The problem, however, is domestic inflation. Higher import prices, especially for products with inelastic demand (most notably petroleum), will spill into domestic inflation numbers. Not a feasible solution, therefore, for an economy still having high inflation.

(4) Investment Incentives: Another way of shifting the BB curve to the right is by increasing capital inflows without changing domestic interest rates. There are several innovative ways of doing this. One way is to offer higher interest rates to NRI depositors (but not to domestic depositors). This will likely lead to an inflow of funds, but will come along with a host of implementation problems. Another option is to attract FDI by freeing up certain sectors. This, again, will be politically difficult for a fragile Government.

As one can see, there is no solution that offers to stop the rupee without extracting a cost. A general principle applied in macroeconomics is that domestic problems should be solved using domestic tools (IS, LM) and foreign problems using foreign tools (BB). This removes monetary contraction and fiscal expansion from our menu. 

Hence, the choice before the Government is essentially to either take the politically volatile decision of courting foreign funds by freeing investments such as FDI **, or to risk inflation caused due to currency depreciation.

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* - Of course, a current account deficit need not necessarily result in a balance of payments deficit. However, because the RBI is having to sell dollars to stabilize the rupee, we can conclude that the present current account deficit is accompanied by a balance of payments deficit.

** - Note that this will merely increase the surplus in our capital account, but leave the current account unchanged. In fact, the current account might worsen further as imports increase due to greater economic activity.