For whom the rupee falls?
by Virendra Parekh on 01 Dec 2011 2 Comments

Under the smokescreen of responding to a crisis, the government is sneaking in a number of controversial measures for the benefit of foreigners, which it would not have dared take otherwise.


The second fastest-growing economy in the world now has the unenviable distinction of having the fastest falling financial markets in Asia. Global tremors are shaking the Indian currency and the stock markets as investors flee emerging economies amid a worsening of the European debt crisis and political stalemate in the US over cutting deficit. Mismanagement of a decelerating economy by a clueless government at home has only compounded the problems.


The Indian currency has lost around 19 per cent against the dollar from a recent high of Rs. 43.95 on 27 July 2011 to touch an all-time low of 52.35 on November 23. The BSE Sensex plunged 2732 points or 17.40 per cent to 15700 during this period. Both have fallen much steeper than any other corresponding index in Asia.


The rupee is at all-time low and, despite some valiant though belated firefighting by the Reserve Bank, it cannot be said to have bottomed out.


For one, the fortunes of the rupee are at present tightly linked with the euro, which is in the throes of an existential crisis. Everything that weakens euro strengthens, by default as it were, the dollar. And whatever strengthens the dollar automatically weakens the rupee, as also many other currencies. In this globalised world, India is paying for the profligacy of European countries and political chicanery of their leaders.


The debt crisis in Europe shows no signs early resolution. What began as a problem affecting the smaller peripheral economies of Ireland, Greece and Portugal, soon started buffeting Spain and Italy, with even France facing investor anxieties. The contagion has now reached the heart of the euro zone: an auction of new German bonds failed to generate enough demand for the full amount, causing a drop in bond prices. European banks are facing a liquidity crunch, interbank lending has been severely hit and there are sings that corporates are withdrawing deposits from banks in Spain, Italy, France and Belgium.


Many economists have come to the conclusion that the euro zone is unlikely to survive the crisis in its current form, with some envisaging a “core” group that would exclude Greece.


Jittery over the prospects of a long and painful process of economic restructuring of the euro zone, foreign investors have lost appetite for risk and begun pulling capital out of emerging markets, including India (now perceived to be risky places) and taking it to the safe haven of dollar assets. The American economy is certainly not in a great shape. But the US is getting, once again, the unfair advantage of having a currency that is the reserve currency of the world.


But it is unfair to blame only foreigners for the plight of the rupee. India’s external account has been worsening steadily over the past several quarters. Actually, what should surprise us is the earlier strength of the rupee, rather than its recent depreciation. India’s imports of goods exceed their exports by as much as 50 per cent. After taking into account the trade in services and remittances from Indians overseas, the total current account deficit (the gap between what a country earns from exports, remittances and other courses of current forex income, and what it pays out) is running at about three per cent of GDP, a higher level than what most economists consider safe.


The current account deficit (CAD) widened from $15.7 billion in 2007-08 to $44.3 billion in 2010-11 and is likely to exceed $50 billion this fiscal. Ordinarily, this dollar deficit should have weakened the currency. But the rupee rode high on the back of massive inflows of foreign capital in search of better returns.


Foreign investors flush with freshly minted cheap dollars yielding near-zero returns at home, and lured by the Indian economy roaring away at 8 per cent, poured money in India’s debt and equity markets and more than made up its shortfall of dollars. Forex capital inflows amounted to a heady $106.6 billion in 2007-08 and $55-60 billion in 2009-10 and 2010-11. But today, inflows are drying up - as they did in 2008-09 - even as the CAD is rising. So it is natural that the rupee should have dropped in value.


At the same time, the Indian economy is losing steam, partly engineered by the Reserve Bank of India through a long series of key interest rate hikes in a bid to control inflation. Apart from the exchange rate, two other macro-economic indicators have long been flashing red.


Inflation remains close to 10 per cent, despite repeated interest rate hikes with their debilitating impact on growth. And fiscal deficit is almost certain to overshoot the budgeted limit of 4.6 per cent of GDP owing to shortfall in revenues. The slew of government corruption scandals and the worsening economic situation are diminishing India’s appeal to foreign investors and piling pressure on the rupee.


In recent years, the rupee has suffered a steep fall (Rs. 52.18 to a dollar in March 2009) and bounced back. Can it perform that feat again?


The chances of that happening must be rated slim, for two reasons. First, the imbalance on the external account deficit is substantial and has got larger. India has a trade deficit equivalent to 7.6 per cent of its GDP and a current account deficit of around 3 per cent of GDP.


Secondly, the forex reserves position is relatively weaker. In 2008, India’s foreign exchange reserves could finance 12 months of imports; that cover is now down to less than eight months. India’s external debt at $317 billion at the end of June was higher than the forex reserves of $314 billion. Moreover, these are not free reserves as they comprise NRI deposits and FII investments which are repayable on demand. Debt worth $137 billion is due for repayment by next year when there could be a surge in demand for the US dollar amid slowing portfolio flows.


Against this backdrop the Reserve Bank of India has done well to not intervene or try to stop the slide. It has committed itself publicly to the policy of managing volatility in exchange rate and ensuring that it (volatility) does not impair macro economic stability. This means that the central bank will not use the accumulated foreign exchange reserves to shore up the currency or defend a particular exchange rate.


This policy has some merit. It is far better for the rupee to find its true value than for the country to be in Greece’s position: stuck with an expensive currency and, therefore, no manoeuvrability on the trade account.


The RBI has another, equally weighty reason for not intervening. Selling dollars on large scale at this juncture would suck the Indian currency from the system and put further upward pressure on interest rates. This has implications for investment, production, growth and tax collections.


However, this does not mean that the RBI is beyond criticism. According to Mr. A.V. Rajwade, corporate consultant and columnist, the central bank is on the horns of a dilemma which it has invited upon itself by allowing the rupee to fluctuate violently and appreciate significantly. During the last 3 years when it never intervened to check the rupee’s rise, the trade deficit widened year after year after year. If the RBI had followed the policy of maintaining a competitive exchange rate with the help of frequent interventions, the trade deficit would not have widened as much as it has and the currency would not have been in a free fall as it is now.


Intriguingly, even as the rupee was in a free fall and industry wanted the central bank to intervene and shore up the rupee, RBI deputy governor Subir Gokarn said it would be a “risky strategy” if the bank were to “try and resist or try and do something for which we do not have a capacity.” A high official from the finance ministry also said that the RBI’s capacity to intervene in the market was limited. These defeatist statements were uncalled for. They implied it was like open season on the currency.


But there was a method in this madness, it seems. Given a problem, ordinary people try to find out how they can get out of it. Smart people try to find out what they can get out of it. And we are blessed with a smart government when it comes to its playing its own games. Even as global oil prices are steady or falling, the depreciation of the rupee could be used by oil companies (both in public sector and in private sector) to push for a steep price hike in prices, if not total deregulation, of diesel and LPG.


The government has already cleared FDI in multi-brand retailing, paving the road for entry of global giants like Wal-Mart. It is also displaying unusual urgency in permitting foreign airlines to finally acquire equity stake in domestic airlines. It has already increased the ceiling for FII investment in government debt paper as also in private sector bonds.


All this is done in the name of attracting additional foreign investment in the country and easing pressure on the rupee, besides promoting growth. As everybody knows, dollars do not start pouring in as soon as you throw open a sector to foreign investors. There is no doubt that controversial decisions, which the government would not have dared take otherwise, are sought to be shoved down people’s throat under the smokescreen of responding to a crisis.


Dangerous implications of some of these measures (e.g. FDI in multi-brand retail) are widely known; those of others are not so well known e.g. higher FII investment in government debt paper. At present, the external component in India's total public debt is hardly 4 per cent, and that is one of the reasons it has not gone the way of Greece and other countries which got in trouble because of their own governments’ excessive borrowings in foreign currency. The opening of the debt window will lead to a higher external debt-to-GDP ratio. Rating agencies like Moody’s have pointed out that the relatively high public debt (it includes external debt too) at close to 70 per cent of the GDP is preventing India from graduating to an investment grade rating. It is currently at Ba1, the highest in the junk grade.


A weaker rupee deepens inflationary pressures as it makes all imports more expensive, adding to inflation and making the life of the common man more miserable. The most important import, of course, is oil. If the dollar becomes costlier by one rupee, it entails under-recoveries of Rs. 8000 crore for the oil marketing companies. A number of consumer goods, ranging from imported edible oil to mobile phones and cars (not to mention gold) have already climbed up.


The steep depreciation of the rupee has serious implications for the corporate sector. A cheaper rupee at a time when the Chinese yuan has been trending up against the dollar should provide exporters with renewed opportunity. As imports become more expensive, domestic suppliers will be able to offer substitutes for imports. For instance, domestic producers of power generation equipment (like Bharat Heavy Electricals) may be able to compete more effectively against Chinese suppliers.


However, where import substitution is not possible (as with oil, coal and gas, consumer durables with imported components and many industrial intermediates), the higher cost of imports will add to the problem of inflation. At a time when high interest rates and high input costs were putting pressure on margins, a fall in rupee could push up costs for companies which depend on imported raw materials or use energy intensive processes or have foreign currency debt to repay.


In 2011 alone, Indian companies have raised external commercial borrowings worth about $30 billion. So, given the 18 per cent depreciation of the rupee against the dollar so far, the mark-to-market losses on this count alone work out to $5.4 billion or over Rs. 27,500 crore.


As the global situation remains uncertain, as economic fundamentals are against the Indian currency and as the central bank would intervene only to contain excessive volatility, the rupee could slide further. If there is a great external shock (formal default by Greece, run on European banks, disintegration of euro zone, nuclear explosion by Iran or Israeli attack on Iran), the downfall of the Indian currency may receive a further impetus and it may even sink up to Rs. 60 to a dollar.


Apart from exporters with open positions, there is one more class of Indians that is quietly smiling at the prospect of sunken rupee.


Unscrupulous politicians, bureaucrats and businessmen, who have stashed their illicit wealth abroad, are bringing some of it back to the country in the name of exports. The anonymity and security of their vaults can no longer be taken for granted. The repeated promises and assurances from the government of impending action to detect these accounts and take appropriate action are actually a wake up call for the corrupt.


In the circumstances, it makes eminent sense at least to shift the money to a safer place. It would be even better if the money can be laundered and brought back to India, repatriation becomes an attractive option. Getting more rupee per dollar is the icing on the cake. 


The author is Executive Editor, Corporate India, and lives in Mumbai

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