Posted by: Uma Shashikant and Deepa Vasudevan on Thu, Jul 18th, 2013
The Rupee Logjam
India has historically spent more foreign exchange on imports than it earns through exports and has a chronic current account deficit (CAD). Inflows on the capital account have been more than enough to fill the gap in the past. How the rupee behaves is mostly a function of how much capital came in. See Pic 1 below to see how the rupee touched Rs.38 to a dollar in 2008 when huge capital inflows more than made up for the CAD and why it depreciated rapidly in the recent years when the CAD has gone out of control.
Pic 1: The Current Account Deficit (CAD) and Capital Account Surplus (CAS)
In the post-2008 years, the magnitude of CAD has grown immensely, and that of capital inflows has reduced, so that inflows are barely enough. In 2011-12, for instance, an additional $12 billion of reserves was needed to plug the gap (CAD was 4.2% of GDP that year). After some urgent measures to attract foreign investment and curb gold imports, the balance was just maintained in 2012-13.
Roughly half of the capital account consists of "hot money" - portfolio inflows and NRI deposits - which are known to be short term and volatile. This fiscal has begun badly: foreign portfolio investors have pulled out $10 billion from the market, and fear of an impending end to quantitative easing by the US has seen money moving out of emerging markets. In case there is a substantial reversal of flows, at least half of the CAD ($30-$40 billion) is at risk of not being funded through the capital account. An excessive dependence on unreliable inflows has been set up; which keeps markets on edge.
The more dependable FDI accounts for 20%-30% of inflows. The government has been releasing a slew of measures to attract foreign capital (notice the steps to ease FDI flows this week). It could turn out to be case of too little too late, since foreign investors lose money when they invest in a currency that is depreciating. The case for inevsting in India has been weakened over the years due to policy delays and reversals, hurdles to investing and slow decision-making. A weak currency will only make it worse.
It is this vulnerability of the economy that has resulted in steady rupee depreciation. The sudden pullout of hot money from several emerging markets in June pushed the exchange rate to levels of Rs. 60 per US$ (Pic 2). A falling rupee worsens the CAD because fuel imports form a third of total imports.
Pic 2: The INR/USD Exchange Rate
There have been calls for RBI intervention to stem the fall. But RBI is heavily constrained by an inherent conflict in policy objectives if it tries to protect the currency. Any measure it takes to protect the currency either on the demand or supply side will hurt what it is trying to do with the monetary policy.
If RBI were to sell dollars in the market, to shore up the supply it would end up having to take out an equivalent amount of rupees from the system. It has been pursuing an easy money policy with the view to encouraging growth. It would hurt its own policy outcomes if it reduced interest rates on the one hand, and sucked out rupees from the system on the other. If it took a rupee-side view of the problem, and increased interest rates or reduced liquidity, as it did this week, it expected the reduced supply of rupees to curb speculation in the currency markets and shore up its value, while also attracting inflows with a higher rate.
(RBI raised short term borrowing rates, reduced bank borrowing limits, and announced an OMO to lower money supply).
The markets have expectedly reacted negatively. These tightening measures will hurt the GDP growth rates further. Most market participants have begun to expect a hike in repo rate in the July 30 policy review, which reverses several assumptions about a low-rate led revival in economic growth, which in turn makes India an attractive destination for foreign capital. Therefore whatever the solutions the government with come up with, including the issue of a sovereign bond, they run the risk of being implemented in adverse local and global conditions, and of being desperate measures after the currency has already depreciated. The underlying problem remains: India needs to attract $80-$90 billion in foreign inflows to match its CAD.
The only component of the BoP that can be controlled is export growth. A falling rupee makes that so much more feasible. By developing infrastructure and facilities to boost exports, India can become an exporting powerhouse, solving the CAD problem directly by becoming a net exporter than importer of goods and services from the world. A weak China, a slowly reviving US, easy domestic interest rate and a falling rupee provide a good opportunity to produce globally and fix the deficit for good. This crisis and the logjam it has created should lead to focusing on the long-term solution rather than reacting to the immediate problem.