Volatility in India's foreign exchange markets has forced the Reserve Bank of India (RBI) to change course. In July, the RBI suddenly reversed the agenda of easing money supply and reducing interest rates that it had been consistently pursuing for more than two years now. To further that agenda, the RBI had periodically reduced the Cash Reserve Ratio (CRR) applicable to the banking system, and the Bank Rate, or the rate at which the central bank provides credit to the banking system. The most recent set of such reductions was announced on April 1, 2000. Four months later, priorities have changed. The Bank Rate which had been brought down in six instalments from 11 per cent in January 1998 to 7 per cent as recently as April 2000 was, on 21 July, hiked by one percentage point to 8 per cent. The CRR too was raised by half a percentage point to 8.5 per cent. The RBI had decided to stabilise the rupee by choking off credit and rendering it more expensive.
 
This sudden reversal in policy came as a reaction to an acceleration of the hitherto gradual depreciation in the value of the rupee. The rupee, which traded at 43.66 to the dollar at the beginning of May 2000, fell to 44.58 by the end of that month and stood at 44.7 around the middle of July. , The RBI¹s announcement came when this gradual depreciation gathered momentum, leading to a 15 paise intra-day fall in the value of the rupee relative to the dollar, which took it below the psychological milestone of Rs. 45 to the dollar. The RBI¹s Bank Rate and CRR hike came as a swift reaction aimed halting this accelerated depreciation.
 
There are three ways in which a squeeze in liquidity and a hike in interest rates can affect the dollar¹s value in a relatively free foreign exchange market. To start with, in the medium term, it could do so by affecting the level of economic activity. The higher cost of and reduced access to finance would, by curtailing debt incurred to sustain current operations and undertake investment, dampen economic activity and reduce import demand. The consequent improvement in the trade and current account balances, if any, can strengthen the rupee. Secondly, by setting a higher floor to interest rates, the hike in the Bank Rate could increase returns earned by financial investors, thereby attracting financial inflows from abroad. The consequent increase in dollar supply in domestic foreign exchange markets could prop up the rupee. Finally, by making access to rupee resources more difficult and more expensive it can discourage speculators from borrowing rupee funds to speculate on the dollar. To the extent that speculation is responsible for the depreciation of the rupee, this would serve to strengthen the currency.
 
The intent of the RBI¹s manoeuvre is thus clear. What is puzzling, however, is the reason why the observed decline in the value of the rupee, which should be considered Œnormal¹ in the world of "market-determined" exchange rates that financial liberalisation has put in place, should have invited such a knee-jerk reaction. In fact, there are many who believe that there is a strong case for rupee depreciation. To start with, the dollar has in the recent past appreciated substantially against the currencies of other developed countries, and if the rupee remains stable vis-à-vis the dollar, India¹s competitiveness in developed country markets (other than the US) would be affected adversely. Further, even though exchange rates in East Asia have risen from the troughs they reached during the financial crisis of 1997-98, they are still well below their pre-crisis levels. This has given exporters from these countries, which are India¹s competitors in world markets, an advantage. For these and other reasons, rupee depreciation appeared warranted, especially since trade liberalisation had rendered the use of subsidies as a measure of promoting exports difficult.
 
In practice, however, an unusual combination of circumstances had ensured that the rupee was under pressure to appreciate rather than depreciate. One such circumstance was India¹s comfortable current account deficit in recent years, including in 1999-2000. Even though oil prices rose sharply that year and substantially increased India¹s oil import bill, non-oil imports remained sluggish. This was because the much touted recovery in the industrial sector did not prove strong enough to increase the demand for capital goods, components and intermediates, despite the increase in the import intensity of domestic production. On the other hand remittances and earnings  from software exports rose, keeping the current account deficit under control. The resulting low level of the current account was itself enough to contribute to stability in the value of the rupee.
 
But that was not all. The year 1999-2000 was one in which foreign investment inflows into the country , having fallen from $5.4 billion in 19997-98 to $2.4 billion in 1998-999, rose once again to touch $5.2 billion. This volatility was not on account of fluctuations in the volume of foreign direct investment.  In fact, foreign direct investment after having peaked at $3.6 billion in 1997-98, has fallen consistently to $2.5 billion in 1998-99 and $2.2 billion in 1999-2000. The fluctuations were on account of sharp variations in the volume of portfolio investments in the form of ADR/GDR issues, foreign institutional investment and investment by offshore funds. The volume of such investments, which fell from a net inflow of $3.3 billion in 1996-97 to $1.8 in 1997-98 and a negative (outflow) of $0.06 billion in 1998-99, rose sharply to $5.2 billion in 1999-2000.