The government's helplessness over a falling rupee is very real. Under textbook conditions, monetary policy faces an impossible trinity of keeping both exchange and interest rates free in an environment of unimpeded capital flows. The rupee is in a managed float; India's capital account is not free. Despite this the rupee has plummeted 15% from the beginning of the year as the trade gap widened and international investors fled to the safety of dollar debt. The copybook response to capital flight is monetary tightening, but that option is already nearing exhaustion after a bruising battle with inflation at home. If the Reserve Bank of India (RBI) now starts selling dollars it will have to suck more rupees out of the system, pushing up interest rates further. The Indian economy has lost quite a bit of steam due to the deliberate ministrations of its policymakers. It could begin to sputter if the government tries to prop up the rupee.
The other policy response does not hold out great hope either. The financial crisis of 2008 has led to a reassessment of capital controls worldwide. Some degree of control is now being advocated by even the likes of the International Monetary Fund, whose sole mantra till recently was free markets. India, however, already has far tighter capital controls than what is being contemplated in the global arena. A further tightening would be an unfortunate throwback. Our policy towards foreign capital has been easing ever so gradually since India opened up to the world in 1991. This despite the fact that we save less than we invest and import more than we export. These two gaps, adding up to nearly 6% of the gross domestic product, have per force to be bridged by money from abroad. Foreign capital has been persistently financing India's fiscal and trade deficits and our policymakers must heed it when it seeks greater access to our economy.
So if interest rates cannot be raised and capital flows cannot be curbed, the Indian economy must learn to live with the prospects of a falling rupee. Unless the government gets serious about controlling its bloated expenditure — particularly subsidised energy, most of which we import — the economy remains vulnerable to hot money flows. As it is, the 2011 capital flight has caught our policymakers on the wrong foot. India's tight monetary and loose fiscal stances are working at cross-purposes. This inconsistency has been allowed to linger since the RBI started on a series of 13 interest rate hikes in March 2010. With the rupee headed further downhill, the government should wake up and smell the coffee.