RBI can't save the rupee

Financial Express, 17th May 2012

RBI continued to intervene in the rupee spot and forward markets in an attempt to prevent a further depreciation of the rupee. Earlier last month, attempts to contain rupee depreciation started with raising duties on gold imports. But that did not work. Next, caps on interest rates for NRI deposits were raised. But they also did not have the desired effect. In a desperate move, RBI ordered exporters to sell half the dollars in their accounts. But the rupee continued to weaken. Now that RBI is said to be intervening in a big way, there may be little that the central bank can do to prevent the depreciation as it is caused by fundamental macroeconomic weaknesses.

The government needs to have a clear strategy on the steps it would take in case there is a sudden outflow of dollars from India triggered by some unforeseen event. RBI's war chest is not unlimited and with a 4.3% current account deficit and an economy facing stagflation, it is not unthinkable that private capital inflows may decline, putting further pressure on the rupee. If there is another policy rate cut, a further credit rating downgrade, a reopening of the Mauritius treaty or any other event that acts as a trigger for confidence worsening, both domestic and foreign capital can flow out of India.

Intervention can be useful only when the pressure on the currency is transitory. RBI has already spent more than $20 billion this year until two months ago in defending the rupee. Reducing day-to-day volatility and smoothing out currency depreciation has few known benefits. Further, the current pressure on the rupee is not caused by temporary factors. India has been witnessing inflation higher than in the US for many years now. This resulted in a real appreciation. This has hurt domestic industry as foreign goods became cheaper than ours, making both our exports and import-competing goods less attractive. Imports, even other than gold imports, have been rising. Non-oil non-gold imports have seen a year-on-year growth of 20% so far. Exports growth is now seen to be slowing. If the current account deficit has increased in response to a real appreciation of the rupee, it should come as no surprise. Despite many years of inflation, macroeconomic policy has not focused adequately on controlling it. The government has not had the political will to cut the fiscal deficit, while RBI remains burdened with multiple mandates.

A rupee depreciation can be bad for balance sheets if a large number of companies have borrowed in dollars. A large number of FCCBs are due this year and repayment may pose a problem since with the decline in stock prices, lenders prefer to get their money back instead of using the option of buying shares. A depreciated rupee could pose a bigger mismatch for firms. Further, the depreciation may further worsen the inflation. Oil prices would be higher in rupees, posing a bigger burden to the oil and fertiliser subsidy bill of the government.

However, despite the above drawbacks, depreciation would help to reduce real exchange rate appreciation and act as an automatic stabiliser for the economy. It would push growth through expansion of the tradable sector. It is unlikely that if it becomes apparent that RBI could lose say $100 billion in trying to defend the rupee, it would sell dollars. Another difficulty with selling dollars is the impact on liquidity. RBI has to sterilise its intervention if it does not want to suck rupees out of the market. In recent months it has been seen that RBI intervention has led to tightness in the money market.

One reason why the rupee was holding up, despite higher inflation, was the large foreign private capital inflows into the country. Private equity flows, both portfolio and foreign direct investment had continued to flow to India as India offered an attractive investment destination. With increasing uncertainty on the India growth story, this situation has changed in recent months. Government policy, however, has tended to assume that the India story remains strong. Repeated statements by policy makers that the growth rate is high, and higher than in other emerging markets, have failed to recognise that falling government investment in infrastructure, the policy muddle and governance crisis faced by India in recent years will have consequences for growth and capital flows.

The fiscal deficit is high and rising but the government has not appeared to worry that it could spill over on to the current account. The current account deficit represents the gap between savings and investment in the domestic economy. With households savings lower and a larger fiscal deficit, this deficit is spilling over on to the current account, leading to a twin deficit problem. This again should come as no surprise.

One of the lessons from 1991 was that when a large fiscal deficit spills over to the balance of payment, there can be a crisis. As private capital inflows were then not permitted, to finance the deficit the government had to borrow from the IMF. That option is open today, but is not one that the government would wish to exercise. While there is no magic bullet, and the way to restore macroeconomic stability is long-term reform, but in the short run, the best solution at present is for the government to change the petroleum price policy. This will not only cut the fiscal deficit, restore confidence in the reform process and in this government, but also raise the price of imported oil and to the extent that in the medium-run oil imports are price-elastic, reduce the import bill. At the same time, the government needs to put on the back-burner all plans of tax reform that can hurt foreigners. It should adopt principles of residence-based taxation, and implement GST as soon as possible if it wishes to raise tax revenues.

It is important to recognise that we have a problem that poses a serious risk, to take steps to prevent it getting worse, and to be ready in case it does.

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