š§ Should RBI Stop Saving the Rupee?
The RBI is sparing no cost to stop the rupee's fall because we are a net importer of goods. But what if it stopped doing that?
The RBI currently has one goal: defend the rupee at any cost.
But this goal has a massive price tag: $90 billion to be exact.Ā
Thatās how much the RBI has spent on defending the rupee (by selling forex reserves) this year.
Despite all these efforts, the rupee fell to its lowest ever last week: Rs. 81.26.
But why is the rupee constantly declining and more importantly, should the RBI stop defending it?
š¤ Whatās Going on with the Rupee?
The rupeeās fall is directly linked to the USā mission to curb inflation.
The US central bank has been constantly raising interest rates to bring down the countryās insane inflation (higher interest rates = less money in the economy = falling demand = lower inflation).
This week it raised interest rates to their highest level since 2008.
This means USā Treasury bonds, considered one of the safest investment instruments, are now giving the highest returns than they have in a decade.
Thatās why a lot of investors are taking their money out of emerging markets like India, which are riskier and putting them in the US.
This is increasing demand for dollars (because thatās what you need to invest in the US) and decreasing the demand for the rupee.
So, the dollar is rising and the rupee is declining.
And we are trying to prevent this because if the rupee falls we have to pay more money to import goods and services, which will lead to trade deficit.
But in trying to prevent this, the RBI is aggressively selling dollars (to increase supply in the market) from our forex reserves (You can read more about this here).
Till now, this policy seemed sound. But now thereās a twist in the tale.
š² A New Crisis Ahead?
Our banking system is now facing a liquidity deficit. Huh?
Liquidity is the amount of money into our banking systems.
You see, all our commercial banks store some money with the RBI, which they can borrow in case they need extra funds to give money back to customers.
So, if banks are collectively depositing more money than they are borrowing, there is a liquidity surplus. But if they are borrowing more and depositing less, RBI has less money in its reserves and there is a liquidity crunch.
Right now there is a liquidity crunch of ā¹21,873.4 crores.
How did this happen?
Well, this is the time to pay advance income tax, so a lot of companies have withdrawn money from banks.Ā
Also, as our economy is now finally recovering, demand for loans is going up. Credit demand has hit a 9-year high of 15.5% in the last week of August.
Banks don't have enough money to support all of this and are borrowing more from the central bank leading to a deficit of funds there.
While these situations seem temporary, our forex spending could further increase the liquidity crunch by increasing RBI's funding deficit.
So, what if we stopped selling forex to save the rupee?
š¤ The Other Side of the Debate
While the RBI's attempts to save the rupee make sense, because we are a net importer, not saving the rupee could also be considered a good decision.
The constant headlines about the rupeeās fall to a new low may be worrying, but other data indicates that the rupee is overvalued (indicating that the dollar is undervalued).
The Real Effective Exchange Rate* of the rupee is 103.86.
A REER of over 100 means that a countryās imports are cheaper and its exports are expensive.
And that is bad. Cheap imports means we end up buying more imported stuff, while expensive exports mean that other people end up buying less of our stuff.
So, we end up spending more than we earn. Result? Trade deficit.
Which is why, maybe the RBI should leave the rupee alone.
A falling rupee will automatically reduce non-oil imports and make our exports cheaper and more in demand.
In fact, this is how China became a major world exporter.
The country tries to keep the yuan undervalued so more people will buy its cheaper products.
But ReadOn, wonāt this increase our oil import bills?
Yes, but oil prices are falling right now because of fears of recession. So, it may not increase our bill by that much.
Whatās more, the RBI is also set to increasing interest rates again.
That, plus the fact that a lot of people are now betting on India to grow while the West faces a recession, may boost the rupee in the longer run.
So, burning money to defend it right now, especially when the Fed is single mindedly focused on raising interest rates, could be counterproductive.
But that's just the other side of the debate. Saving the rupee has a lot of benefits, and more immediate ones, which is why the RBI is hell-bent on doing so.
However, data suggests that despite all efforts the rupee is going to hit newer lows in the coming months and with declining forex reserves, the RBI may not have a choice but to let it continue its fall.
We will have to wait and watch to see where the rupee lands.
ā”In a line: The RBI is trying its best to save the rupee but soon it may not have a choice to continue doing that.
š”Quick question: What other measures can the RBI take to save the rupee?
š¤ Noob's Corner: The Real Effective Exchange Rate is a metric that determines the real effective value of a currency by comparing its value to a whole basket of other currencies.
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How will 100 exchange rate make imports cheaper and imports costlier?