In 2013, the fall in emerging market currencies stemmed from a mere mention of unwinding of the U.S. Federal Reserve’s quantitative easing program. Economies tagged as the ‘Fragile Five’—those with high twin deficits and inflation—were worst hit. India is in better shape now. The fiscal deficit has been decisively brought down to 3.5 percent from 4.8 percent of GDP. Remarkable improvement has also been made in addressing inflation. The current account deficit is likely to be close to 2.6 percent in FY19, as per India Ratings’ expectations, compared to 4.7 percent in FY13. A strong U.S. economy could call for greater pressure on interest rates and lead to a stronger dollar. Seeing what’s happening across economies like Indonesia, suggests that the RBI’s cautious approach on allowing foreign participation (especially in the bond markets) is justified. Another option is to try and attract foreign fund flows over a short period by creating an incentive structure through a specific instrument or arrangement. Such schemes are one-off fixes that can be used to buy time while addressing short-term anomalies. The RBI sterilizes foreign inflows by buying dollars, which, in turn, leads to rupee liquidity being pumped into the domestic markets. If the RBI chooses to sell bonds through open market operations to absorb surplus liquidity, it could lead to an increase in domestic interest rates. The current pressure on currencies like the rupee is driven more by fundamentals and policies. Thus, it may be difficult to stand in the way of the adjustment in the exchange rate except by reducing excessive volatility.

(Bloomberg Quint)