Rupee Fall: Impossible trinity is pushing RBI toward relaxing rupee grip

The Reserve Bank of India is starting to relent on its tight control of the rupee, acknowledging the ‘Impossible Trinity’ of simultaneously having a fixed exchange rate, open capital account and an independent monetary policy.

New RBI Governor Sanjay Malhotra faces tough challenges early in his tenure — a slowing economy, rising oil prices threatening to stoke inflation, and a weakening currency. His predecessor staved off investor calls for rate cuts and defended the rupee, but Malhotra is showing signs of adopting a more hands-off approach to currency management.

The governor has shown a willingness to allow the rupee to move more freely in tandem with Asian peers while still intervening in the foreign-exchange market to curb excessive moves, Bloomberg News reported on Tuesday, citing people familiar with the regulator’s thinking. Malhotra didn’t raise any objections when his team explained the recent swings in the rupee and the need to allow it to depreciate, according to the report.

Investors are counting on Malhotra to maintain the policy shift, hoping that ending the tight grip would improve exports and allow the central bank to stick to its main mandate of keeping prices under control.

“In the current uncertain global environment, the RBI should retain its focus on inflation, i.e., monetary policy independence, and let fluctuation in capital flows reflect in the currency movement,” said Vivek Kumar, an economist at QuantEco Research.

The RBI’s previous approach drove up the rupee’s inflation-adjusted trade competitiveness to a historic high of 108.14 in November, suggesting an overvaluation of about 8%.

That undermined India’s exports, worsening challenges as the strong dollar and rising crude prices weigh on investor sentiment in the net oil-importing economy. Global funds have already yanked a combined $3.3 billion from local shares and bonds so far this year, further pressuring the rupee to record lows.

The RBI’s new approach, if adopted, will help halt further overvaluation in the rupee’s real effective exchange rate, Kumar said.

Flexible Approach

Malhotra has yet to publicly outline his policy priorities, but the indications of a more flexible approach to managing the currency marks a shift from his predecessor, Shaktikanta Das.

During Das’s term, the RBI built up reserves of more than $700 billion and then used it to defend the currency even in the face of a rallying dollar. While the iron grip pushed down the rupee’s volatility to the lowest among emerging markets, the policy had side-effects.

“The magnitude of FX intervention since October has been substantial and is resulting in adverse effects, such as tighter banking liquidity and higher short-term rates at a time of weakening growth,” said Sonal Varma, chief economist India and Asia ex-Japan at Nomura Holdings Inc.

The RBI did cut the cash reserve ratio by 50 basis points in December to ease the squeeze, and traders say it also used dollar-rupee swaps in the foreign exchange market to boost liquidity. Despite these steps, bankers and investors are calling for more steps to support the economy, which has been constrained by two years of unchanged interest rates.

The RBI is due to review policy rates next month, and there will be tough choices to make. Inflation moderated in December, but concerns about a weak rupee limit the central bank’s room to cut rates.

Still, some of India’s biggest fixed-income funds are bracing for the central bank to boost liquidity by investing in money market and shorter corporate debt, while adding duration in sovereign bonds to capture any rate cut gains.

“RBI is facing full force of the Impossible Trinity,” said Gaura Sen Gupta, chief economist at IDFC First Bank. “Monetary policy will need to choose policy independence by embracing faster pace of depreciation or choose currency stability by giving up some of the independence.”