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RBI should let firms manage their currency risks, given the rupee's volatility
The rupee has shown a sharp increase in volatility. It is important for mechanisms to be created so that the Indian economy is more resilient in a world of greater uncertainty, and learns to live with higher volatility. The government must urgently expand the instruments available for firms to hedge their currency exposure.
For those of us who grew up in a controlled economy, it was felt that the RBI would manage the rupee. That age is now behind us. The RBI is largely a spectator of the price that is formed on the market. The rupee's volatility reflects this new reality. The currency options market gives us a measure of what the market expects in terms of future fluctuations. Starting from today's value of 55.91, the market seems to believe that on a one-month horizon, there is a 95 per cent chance that the exchange rate will lie between 52.2 and 59.9. This is a pretty wide range of values, and, with a 5 per cent chance, it will go beyond this range.
Businesses face currency risk when they produce any good that is tradable, even if not actually imported or exported by the firm, or have foreign assets or liabilities. But, located in the mindset that firms should hedge only those exposures that arise from exporting, importing or foreign borrowing, the government's policies on currency risk management have not kept pace with the increasing globalisation of Indian firms. An array of restrictions hold back (a) the flexibility of corporations in reducing their risks and (b) the capability of the currency market in offering protection to corporations.
Corporations are in serious trouble today because our past policies have focused on providing low volatility of the currency and not prepared them for higher rupee flexibility. Nor does the policy framework allow firms to handle rupee volatility well. On one hand, the RBI has rightly got out of trading on the currency market, and the rupee has become much more flexible. As a consequence, rupee volatility has risen, and the rupee is a bigger source of risk for many Indian firms. But on the other hand, the RBI interferes with the things that corporations can do to reduce their risk. In addition, the RBI has prevented the emergence of a capable currency derivatives market, through which this risk can be managed by the corporations. Both elements of this strategy need to be corrected urgently.
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