Rupee has appreciated around 6.1% against the dollar so far in 2017.
What are the shortcomings?
It can cause damage in term of lost exports growth.
There might also be a fall in domestic production due to cheapening imports.
In the current year so far, a total of $31 billion of FPI flows have already come versus an outflow of $2.7 billion in the same period.
This is because interest rates are significantly higher in India.
So around 2/3rdof the FPI flows have been in the form of debt instruments like bonds and securities.
This rate is not slowing down in the near future as the US economy is not reflating at the expected pace.
In this case, FPIs benefit from both the higher interest rates as well as the appreciation of the rupee.
More the inflows, greater will be the appreciation.
This would make India a suitable place for carry trade.
A carry trade is a strategy in which an investor borrows money at a low interest rate in order to invest in an asset that is likely to provide a higher return.
It makes our exchange rate more volatile and also drains our forex.
What has RBI done to tackle this?
RBI has purchased $20 billion, half each in the spot and forward markets.
RBI has tried to slow debt inflows by tightening norms for masala bonds.
The tenors were raised to 3-5 years and an interest rate cap was imposed.
RBI also said that each issue would be cleared by it.
SEBI reinforced this with a temporary ban on new issues.
RBI also tried to increase the maturity profile of FPI investments in G-Securities.
What should be done?
There is no short-term solution to slowing, or reversing the rupee’s appreciation.
There should be sharper cuts in interest rates.
Inflows should be slowed down by promoting outward FDI.
The automatic hikes that were put in place for FPI positions in the bond market two years ago should be relooked to make it serve as a cap to debt inflows and the rupee’s appreciation.
Government has to create enough fiscal space to be able to service the resulting lower interest rates.
RBI has been using stronger rupee as an inflation-fighting tool.
It is time for RBI to shift the focus and estimate the damage caused by an appreciating rupee and to take necessary steps.
