Focus should be inflation, not just halting rupee's fall

A jeweller poses with silver plates in the form of rupee notes at a showroom in New Delhi. India's benchmark 10-year bond yield rose to its highest since the pre-Lehman crisis on Monday as the rupee fell to a record low. Photo: Reuters

Indian stocks have been battered over the past few sessions. The market condition is not unexpected, thanks to over-action by policymakers and over-reaction by stock investors.
The apparent anxiety on the part of the government was that even if the fall of the rupee was inevitable, left entirely to the market, speculative activity would push the economy into a crisis. Presumably, the rupee at 60 to the dollar was the benchmark for intervention.
Concerted action started with the Reserve Bank of India (RBI) raising short rates through marginal standing facility and mopping up cash through the liquidity adjustment facility on July 17, although Governor Duvvuri Subbarao had maintained that the central bank's objective was to reduce exchange rate volatility and not its level. The assumption was probably that the rupee was over-valued and had to find its reasonable level.
Not content with the impact of these initiatives, the RBI announced on Aug. 8 that it would auction 220 billion rupees of government cash management bills [6] every Monday, in a kind of reverse quantitative easing.
Anticipating the central bank's moves, foreign institutional investors had already pulled out $4 billion from investment in debt. The banking system was left dry.
The government complemented the RBI with its own initiatives. It declared its intention to restrict non-essential imports and raised duty on gold to 10 percent. Not that this would stop imports. Gold will be imported through illegal routes and also boost the hawala business.
But that's not the real issue. What triggered the Sensex freefall is the reversal of reforms. Indian companies now cannot invest more than 100 percent of their net worth overseas without RBI approval and remittances by individuals were brought down to $75,000 from $200,000 per financial year. That created fears that government policy has changed direction from reforms to controls.
Was all that necessary? Not really, if the government had addressed a single issue—inflation. No country can maintain a stable currency with high inflation over a long period. The rupee cannot always be propped up by FII and external commercial borrowing inflows. Already, nearly half of the foreign exchange reserves with the RBI are from FII investment.
Inflation should have been the policy target. It eroded the value of the rupee and at 45 to the dollar, the rupee became highly over-valued. Allowing for inflation in India and inflation in the United States in the past five years, 62-63 rupees per dollar would be the real exchange rate. The market, so far, has not exaggerated the fall of the rupee.
Apparently, the government was anxious to take the rupee back to a higher level and introduced measures which, to an extent, negated the steps that had led to the India growth story. The market feared the worst and the bears took full advantage. The damage has been done and it will take time to undo it.

The writer undertakes research on current macroeconomic issues of interest, mainly to industry, as president of RPG Foundation, a private think tank in India.