The RBI has taken a backward step to prevent rupee depreciation by tightening capital controls. It has placed curbs on Indian households and firms investing abroad. But it has done little to defend the rupee which plunged to Rs. 62/ dollar, which is a new low. The Sensex on Friday crashed 769 points. India cannot combine an open economy with an independent monetary policy and a pegged exchange rate. The high exchange rate has been the result of opening up. The government is at the same time anxious to stop currency volatility. To do that, it can either lose monetary policy independence or close the economy. Monetary policy should be independent of US policy which aims to raise rates in the near future. The outcome of the choice of India’s strategy will be reduction in dollar flows, both on the capital and the trade account. FEMA gives Indian authorities powers to restrict all flows. Closing the economy will mean a smaller currency market. At the same time, the derivatives market has to be destroyed so that expectations of depreciation go away. It is then that the RBI can step in and prevent depreciation while retaining much of the reserves.
But what about India’s growth story in this context? Two features of the post-liberalization period were whittling away with trade barriers and barriers to the capital account. Going back on these measures is a retrograde step. Dollar inflows come through remittances from NRIs and ECBs. The restrictive policy can impair growth and stability. Credit ratings of the country can go down. FDI inflow may take a hit. Destroying the derivatives market and imposing capital controls are in the situation counter-productive. Policy makers will perhaps do well to accept rupee flexibility and keep the economy open.