The needless battle
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Rupee defence strategy has deepened the gathering gloom on the India growth story.
The defence of the rupee is going horribly wrong. It has damaged two sources of hope for a growth pick-up in India — monetary policy easing and India's commitment to economic reform. When Chairman Ben Bernanke of the Fed talked about tapering quantitative easing in the US, it was expected that there would be pressure on emerging market currencies. Countries with weaker economies, and with larger current account deficits were likely to see more currency volatility. Instead of talking about this source of pressure, which all emerging markets faced when the dollar started appreciating, the government decided to step in to defend the rupee.
Evidence from across the world shows that a currency defence often fails. Every government trying to stabilise a currency is, therefore, fully aware of the chances of failure. A careful cost-benefit analysis of its strategy is thus an important pre-condition to initiating a defence. Since the global currency turmoil started, the government has been rolling out measures such as currency market controls, import duties on gold and silver, bans on purchase of gold coins and tightening of capital controls to stabilise the rupee. These dirigiste solutions seem oblivious of their likely impact on market expectations. They are based on central planning notions of bans and restrictions being the solutions to the economy's problems.
First came restrictions on currency derivatives markets by Sebi and the RBI. These markets inform people of expectations about the currency. This information may be unpleasant. The government may disagree with it. But instead of listening to what the market was saying, the authorities chose to try to silence it. Restrictions reduced the extent to which people could hedge their currency risk. This was a bad move, especially since the rupee was expected to become more volatile. It made investors less willing to buy rupee assets. Trading volumes on domestic currency derivatives markets fell sharply and the cost of hedging increased. Instead of making rupee assets more attractive, these measures have made them less attractive. Further, the restrictions have undermined the market's confidence about the government's commitment to financial market liberalisation.