The International Monetary Fund has urged India to allow the rupee to absorb more of the economic pressure from elevated oil prices rather than relying heavily on foreign-exchange intervention.
Krishna Srinivasan, director of the IMF’s Asia and Pacific Department, said exchange-rate flexibility should serve as the first line of defense when economies face major external shocks.
The recommendation comes as India confronts a difficult combination of expensive imported energy, capital outflows and pressure on its currency.
The Reserve Bank of India has intervened extensively to stabilize the rupee.
Measures have included dollar sales from foreign-exchange reserves, a special mechanism supplying dollars to oil companies and reserve requirements connected with large foreign-exchange hedge positions.
The rupee had approached record lows earlier in October before recovering roughly 2% following the central bank’s measures.
The IMF’s argument is based on the role currencies can play as economic shock absorbers.
When the cost of imported commodities rises sharply, allowing the exchange rate to adjust can help rebalance demand and external accounts.
Heavy intervention can slow that adjustment, but sustained intervention also consumes foreign-exchange reserves and may provide only temporary relief if the underlying external pressure remains.
India is particularly exposed because it imports most of the crude oil it consumes.
Higher oil prices increase the country’s import bill, raise demand for dollars and can feed inflation through transportation and production costs.
Currency weakness creates another channel of inflation by making dollar-denominated imports more expensive.
That leaves the RBI balancing competing objectives.
Allowing the rupee to weaken too rapidly could amplify inflation and financial-market volatility. Defending it too aggressively could consume reserves and prevent the currency from adjusting to the underlying terms-of-trade shock.
The IMF said some other Indian measures designed to attract capital inflows were broadly constructive.
Those include changes affecting foreign investment in government debt and a large dollar-deposit program aimed at the Indian diaspora.
For markets, the key issue is whether the RBI gradually permits greater exchange-rate flexibility if oil prices remain elevated.
The rupee, India’s foreign-exchange reserves, crude prices and the scale of RBI intervention will provide the clearest evidence of which approach policymakers ultimately choose.
