The Reserve Bank of India (RBI) is conscious of the extreme volatility in the rupee and has a variety of tools to guard against such fluctuations, a deputy governor said, just days after the RBI took measures to bolster foreign currency inflows.
However, a widening current account deficit and a negative balance of payments amid rising imports are still worries for the RBI, Subir Gokarn said, which could limit the central bank's ability to defend the local currency.
"The ultimate determinant on what the exchange rate is going to be, is going to be how much capital comes in, in a way that finances the current account deficit and also the extent to which we reduce the current account deficit because that's really the fundamental driver of the currency," s aid Gokarn, addressing industry members in the southern city of Hyderabad.
The rupee on Friday fell to 53.92 to the dollar - its lowest in 2012. It gained on Monday and posted its biggest percentage rise in six weeks after the government postponed controversial rules on foreign taxation by a year.
India's balance of payments (BoP) slipped into negative territory for the first time in three years in the December quarter as dollar inflows shrunk and imports soared.
Unhappy foreign investors, high crude oil prices and India's need to import 80 percent of its oil could cause the BoP to worsen further.
On Monday, India delayed by a year the rollout of measures to crack down on tax evasion, mollifying overseas investors rattled by uncertainty over proposals that had spurred an exodus of funds and battered the rupee.
The rupee has fallen 7.5 percent since March and the RBI is believed to have stepped into the market to defend the currency on several days last week, according to traders. It was trading down at 53.13 to the dollar on Tuesday.
"Capital flows have dwindled. Demand on current account remains very strong and so the pressure is there," he said.
"So now you can't be putting yourself in a situation of greater and greater vulnerability by running into what is perceived by investors as a situation of inadequate capacity to meet external obligation and that's high risk."
Foreign institutional investors (FIIs) turned net sellers in April, though they were net buyers so far in the calendar year. FIIs sold about $927 million of debt and equity last month.
Gokarn also said the existing tight cash conditions did not seem short-lived, prompting the central bank to announce an unexpected bond purchase programme through open market operation (OMO) this week.
"We have seen over the last few days that the borrowings are now over a lakh crore (one trillion rupees), and since we have already established some sort of a benchmark on what is the comfort zone, we thought this pressure is not just going to be very short-lived. So we decided to do an OMO," Gokarn said.
A lack of government spending and the central bank's dollar sales in the forex market to stem the rupee's fall have kept the liquidity deficit in the banking system at more than double the RBI's comfort zone despite a cumulative cut of 125 basis points in banks' reserve requirements this year.