Rupee Depreciation and RBI's Monetary Policy
Since November last year, the Reserve Bank of India (RBI) has allowed the rupee to weaken against the dollar, ending a nearly two-year peg. Despite interventions in the foreign-exchange (FX) market to limit the rupee’s decline, this has strained monetary policy and tightened liquidity.
Link Between Monetary Policy, Currency Management, and Liquidity
- The rupee weakens when dollar supply in the FX market falls short of demand, discouraging capital inflows.
- The RBI can sell dollars from its FX reserves to prevent rupee depreciation, absorbing rupees and tightening monetary conditions.
- Banks face liquidity issues as they need to provide rupees to buy dollars from the RBI, affecting their balance at the central bank.
Liquidity Challenges
The banking system had a liquidity surplus, but large dollar sales reduced FX reserves from $704 billion in September to $630 billion in January, creating a deficit of ₹1-2 trillion.
RBI's Measures
- The RBI lends funds to banks daily and buys government securities to replenish bank deposits.
- This helps banks maintain necessary funds, although FX interventions have consequences.
- The weighted average call rate (WACR) indicates tightened liquidity, as it moves above the repo rate.
Impact on Monetary Policy
- Mixed signals from the RBI make it unclear if easing monetary conditions is a priority.
- Banks remain hesitant to lower interest rates, impeding the transmission of the repo-rate cut to the economy.
Conclusion
The RBI's exchange rate management undermines monetary policy effectiveness. The central bank should focus on inflation and growth, allowing the exchange rate to adjust naturally.
