The Reserve Bank of India (RBI) is facing a dilemma, known as the “impossible trinity,” where it must choose between maintaining a stable currency or implementing effective monetary policy. According to economist Sengupta, the RBI has wisely chosen to prioritize monetary policy, allowing the rupee to depreciate rather than intervening heavily to prop up its value. This approach has several benefits, including reducing the strain on foreign exchange reserves and maintaining liquidity in the domestic banking system.
When the RBI intervenes to buy rupees, it absorbs liquidity from the system, which can have negative consequences. By not intervening as much, the RBI is able to preserve its freedom to implement monetary policy as needed. This approach is also sustainable in the long term, as the RBI has limited resources and cannot indefinitely support the currency. The pace of depreciation, which has been around 5% year-on-year, suggests that the RBI is allowing the rupee to adjust to market forces.
The RBI’s intervention strategy is also constrained by its limited toolkit. Last year, the rupee was one of the most stable currencies globally, thanks to the RBI’s intervention. However, this came at a cost, as the central bank built up a large short-dollar forward book, which can be used to sterilize intervention in spot markets. This year, the RBI does not have the same level of forward book, limiting its ability to intervene in the currency market.
Overall, the RBI’s approach to managing the rupee’s depreciation is pragmatic and recognizes the limitations of its resources. By prioritizing monetary policy and allowing the currency to adjust to market forces, the RBI is taking a sustainable and long-term view. While the rupee’s depreciation may be a short-term concern, the RBI’s approach is likely to benefit the economy in the long run by preserving its ability to implement effective monetary policy and maintaining stability in the financial system.