Rupee depreciation is inevitable but its volatility is not

RBI should restrain its active forex management while the Centre aims to attract more dollars

- AJIT RANADE

The dollar rupee exchange rate is one of the most important economic variables that affects all aspects of the economy. Whether it is food prices that have an embedded transport fuel or fertilizer cost element, or domestic steel facing import competition, everything is influenced by that rate. Even a business which has wholly domestic inputs costs and sales, with all its transactions in rupees, faces the heat of the dollar rate. This is the shadow impact of the exchange rate. An open economy with a tradeable sector is subject to competition from goods and services traded internationally. The exchange rate thus affects its competitiveness, a lack of which cannot be compensated fully by raising import-duty protection; it is eventually counterproductive because tariffs lead to inflation as locally produced protected goods get expensive.

Inflation is the other most important economic variable. To keep it in check, interest rates must rise. This delicate dance between the three variables of inflation, interest rates and the exchange rate is a major headache for policymakers. It is governed by the 'impossible trinity' theorem, which says that you cannot have independent control of both the exchange rate and interest rate and still maintain an open economy. In other words, a fixed exchange rate and free capital flows are incompatible with an independent monetary policy, thus compromising the nation's autonomy. Despite this so-called trilemma, it is still possible to have partial control of exchange and interest rates and keep the economy partially open. This is the art of policymaking—what economists call 'interior solutions' (i.e., not corner solutions).