The charts Indian policymakers should worry about

In a series of recent pieces, we have been arguing that the just-ended Reserve Bank of India (RBI) regime made a radical change in exchange rate policy, which reduced export competitiveness and rendered monetary policy inappropriate for a slowing economy.

- ABHISHEK ANAND, JOSH FELMAN ARVIND SUBRAMANIAN

And in the process the RBI's intervention to prop up the rupee has led to a reserve loss of about $200 billion over three episodes, with over $50 billion lost since endSeptember alone. In this article, we want to go one step further, emphasising the serious risk this policy creates: The danger of a highly disruptive speculative attack against the rupee.

First things first. There can be no doubt that there has been a radical change of exchange rate policy. Figure 1 shows that whereas for years the rupee had fluctuated up and down in response to market pressures, the exchange rate has since 2022 become as flat as the pitch at the Melbourne Cricket Ground (MCG) in Australia without the bounce of the green turf there. In other words, for the past two years, the RBI has essentially pegged the rupee to the US dollar.

Now, there is an immutable lesson - almost an iron law-derived from umpteen emerging market crises over the last 50 years that countries which run a dollar peg for long periods become vulnerable to speculative attacks. And when these attacks occur, they can force extremely disruptive adjustments. Most famously, an attack against the East Asian pegs in the late 1990s forced major depreciations that bankrupted these countries' major conglomerates (which had borrowed in dollars), as well as the banks that had lent to them. Their growth rates never truly recovered.

Ever since then, emerging market Central banks have tried to protect themselves by building up their foreign exchange war chests. India now holds about $650 billion in reserves, enough to finance nearly a year of imports. The problem is that global financial markets have even more firepower, as China discovered in 2015, when it lost over $1 trillion in reserves yes, trillion with a "t"defending its dollar peg.