Prasanna Tantri, an associate professor of finance at the Indian School of Business (ISB), has issued a stark warning regarding the Reserve Bank of India's (RBI) recent measures to bolster the rupee. Tantri asserts that the RBI's reliance on Foreign Currency Non-Resident (Bank) [FCNR(B)] deposits and other foreign-currency borrowings has introduced five significant risks to India's economic stability.
According to Tantri, these combined efforts have mobilized approximately $136 billion in borrowed dollars, primarily aimed at defending specific exchange-rate levels. This substantial foreign borrowing is projected to elevate India's external debt from an estimated $765 billion to nearly $900 billion.
Professor Tantri's Concerns and Alternatives
Tantri criticized the RBI's approach, arguing that financial decisions should be evaluated before their outcomes are known, emphasizing that escaping disaster does not justify taking unnecessary risks. He dismissed the notion that the rupee was facing a "run," citing India's healthy $650 billion in reserves, strong remittances, and a near-zero current-account deficit as indicators against such a crisis.
Even if a "run" were imminent, Tantri contended that borrowing against a future guarantee should not have been the initial line of defense. He suggested that conventional measures, such as interest-rate increases, measured reserve intervention, and incentives for stable, long-term foreign investment, should have been prioritized. The goal, he argued, should be to prevent disorderly currency movements rather than attempting to control the rupee's direction or defend a predetermined level, pointing to Indonesia as a country that successfully employed such conventional strategies.
The professor also highlighted the impact on domestic liquidity. The drive to prevent rapid rupee appreciation has left the banking system with an estimated ₹7.7 lakh crore (approximately $92 billion) in surplus liquidity, close to the peak observed during the COVID-19 pandemic. Unlike the pandemic era, however, this expansion in reserve money is occurring during a period of strong economic growth, with the RBI having "effectively guaranteed the future rupee value" of much of this capital.
Five Major Risks Identified
1. Clustered Dollar Outflows
A significant portion of the $136 billion in borrowed funds has a known maturity period. While the direct cost of the RBI's exchange-rate guarantee might be manageable even with further rupee depreciation, markets could anticipate these large repayments. This foresight might trigger early exits, transforming scheduled outflows into severe pressure on the rupee, especially if a challenging geopolitical situation arises in the future.
2. Displacement of Ordinary Remittances
FCNR(B) inflows could inadvertently displace ordinary remittances. Non-Resident Indians (NRIs) who might typically send money to India could instead opt for exchange-rate-protected deposits. If this occurs, India would effectively replace stable, non-debt foreign exchange inflows with borrowed dollars that require repayment, shifting from a stable source to a debt obligation.
3. Market Testing of Exchange-Rate Levels
By signaling specific exchange-rate levels it is determined to defend, the central bank provides markets with a clear target. If these levels eventually break despite intervention, the resulting currency adjustment could be abrupt and disruptive, leading to greater volatility.
4. Subsidizing Foreign Investor Exits
Temporary rupee appreciation, a consequence of these measures, could make it easier and more attractive for foreign investors to exit Indian markets. With equities already under pressure, Tantri suggested that India is effectively subsidizing their departures, raising questions about the allocation of economic support.
5. Creation of Enormous Reserve Money
The foreign-currency inflows have significantly added to India's reserve money, which has the potential to multiply through the banking system into increased deposits and credit. Unless this excess liquidity is durably sterilized, Tantri warned that it could create serious inflationary pressure within one to two years, with short-term measures like seven-day reverse-repo auctions merely postponing the problem.
Recommendations for Damage Control
Tantri urged the RBI to initiate "damage control" rather than wait for these risks to materialize. He suggested several measures:
- Absorb excess liquidity more durably through instruments like a higher cash reserve ratio or Market Stabilisation Scheme (MSS) bonds.
- Encourage FCNR(B) depositors to withdraw early and reinvest funds in Indian equities, businesses, or housing, offering limited tax and procedural relief.
- Consider raising interest rates to curb future inflation and provide support for the rupee.
For the government, Tantri recommended pursuing stable foreign-exchange inflows by substantially reducing capital-gains tax, offsetting potential revenue loss by cutting wasteful capital expenditure. While acknowledging increasing Chinese imports as an option, he did not recommend it for strategic reasons. Instead, he expressed hope for a reversal in global conditions, such as a capital return to India due to an AI boom bust, a collapse in crude prices, or another positive supply shock.
The professor concluded with a stark warning: "Finally, we should pray to Krishna, or whichever god one believes in, that no major geopolitical or financial disturbance occurs when these deposits mature."