The temptation to attribute the rupee's weakness entirely to the Iran conflict and higher oil prices, and to assume that it will reverse once the situation normalises, would be a 'misdiagnosis', former RBI Governor D Subbarao said on Monday.
He further said that oil is an important factor, but the rupee has been under pressure for the last few years because of persistent capital outflows and these outflows reflect both domestic and global factors.
"It is tempting to attribute the rupee's weakness entirely to the Iran conflict and higher oil prices, and to assume that it will reverse once the situation normalises. I think that would be a misdiagnosis," he told PTI in an interview.
The rupee settled lower by 3 paise at 94.92 (provisional) against the US dollar on Monday, weighed down by a sharp fall in the domestic equity markets and a recovery in crude oil prices.
On the domestic side, Subbarao said strong investment by Indian households in equities and mutual funds has helped support the market but has also pushed valuations higher.
"Foreign portfolio investors, who compare returns across markets, increasingly see limited upside in Indian assets at current valuations. In relative terms, India has become an expensive market," he said.
While noting that the global pull factors are equally important, Subbarao said capital is flowing towards economies and sectors associated with technological leadership.
"The AI boom, particularly in large US technology firms, has attracted substantial investments," he said, adding that investors are also looking towards semiconductors, biotechnology, advanced manufacturing and renewable-energy technologies, including in the US, Taiwan and China.
According to him, this reflects a shift in global capital allocation: investors are looking not just for growth, but for technological leadership and the returns it can generate.
"India remains one of the fastest-growing major economies, but it is still a relatively marginal player in several of these frontier technologies," Subbarao said.
Subbarao, who served as RBI Governor from 2008 to 2013, observed that the lesson is that strong growth by itself will not guarantee capital inflows or a stronger rupee.
"We need to make Indian assets more attractive by improving productivity, strengthening export competitiveness, reducing unnecessary transaction costs and policy uncertainty, and building capabilities in frontier technologies. We must work on both the current and capital accounts," he said.
Asked if the recent 25-basis-point rate hike by the RBI was justified, Subbarao said that the central bank's decision must be viewed in the context of the difficult trade-offs it faces.
He said the RBI's primary mandate is price stability, but it cannot ignore growth or financial stability and the complication today is that inflationary pressures stem largely from supply shocks - higher oil prices and an adverse monsoon.
"Monetary policy can not produce more oil or improve the monsoon. But if supply pressures persist, inflation expectation can harden and inflation can become generalised," Subbarao said.
Pointing out that there are concerns that early signs of such generalisation are already visible, he said the RBI could not afford to assume that inflation would subside on its own.
Admitting that higher interest rates hurt investment and growth, Subbarao said the purpose of monetary tightening is to moderate demand and prevent inflation from becoming entrenched.
"My view is that a 25-basis-point increase was a right call as a measured response to the risk of inflation becoming entrenched. But it can not solve supply-side inflation or structural rupee weakness," he said.
According to him, the RBI must manage difficult trade-offs: premature tightening can hurt growth, while delayed tightening can make inflation harder to control.
Subbarao explained that the exchange rate is another consideration in the MPC decision although it does not explicitly admit so.
"We need to maintain a sufficiently large gap with the US interest rate to prevent capital outflow. As it happens, that interest-rate differential with the US is at a historically low level," he said, adding that this too may have weighed on the MPC's decision to tighten the interest rate.
Responding to a question on Foreign Currency Non-Resident (FCNR) scheme by RBI, Subbarao said the scheme can be justified as an emergency measure to counter destabilising market sentiment, but the size of the response alone does not establish its success.
"We need sustained investment flows supported by confidence in India's economic prospects, stronger exports and lower vulnerability to imported energy," he said.
Subbarao said he would view the FCNR scheme as a form of insurance.
"The question is whether the immediate benefit of strengthening reserves and stabilising market expectations justifies the implied cost of those funds.What is the case for the scheme? " he asked.
Subbarao explained that when the rupee comes under sustained pressure, the RBI sells dollars to smooth the adjustment, but a significant decline in reserves can unsettle markets and intensify expectations of further depreciation.
"Importers may rush to hedge their dollar requirements, while exporters delay converting their dollar earnings. The expectation must have been that the FCNR flows will provide a circuit breaker and help restore confidence," he said.
According to Subbarao, adding to reserves is not the same as improving the underlying external position.
"FCNR deposits are liabilities that must eventually be repaid with an exchange rate guarantee. Unlike reserves accumulated through export earnings, they create future obligations," he said, adding that the scheme is potentially expensive.