Predicting currency movements is perhaps one of the hardest exercises in economics as it has many variables affecting the market movement. And this phenomenon has tested the expertise and nerves of many analysts and bigwigs including the Government of India’s (GoI) wizards in the last two years.
When INR started depreciating against USD in late July 2011 from the level of 43.9485, very few have imagined that this is going to be a new historical milestone in the journey of Indian Rupees. And within one year, by the end of June 2012, INR touched the all-time high of 57.2165. Some experts were explicitly vocal about Rupee going to touch the low of 70 against the USD. RBI though denied any intervention to put any check on nose-diving Rupee, yet some Open Market Operations (OMOs) and some other measures were taken to avoid the deteriorating CAD situation.
Since last six months or say with the start of the 2013, it seems that Rupee is trying to stabilize at 54-55 level. GoI is having sigh of relief as CAD situation is not worsening any more courtesy falling prices of crude oil and gold. But did our government adopt the right approach while dealing with the matter? In an open market economy a government should not intervene in the foreign exchange market. That’s true. But has the GoI shown its sensible and logical approach when it left the worsening CAD situation unnoticed and went on with its populist measures. And when things got out of control all the government machinery involved in its quick-fix measures and they named it reforms.
In its present stint, P. Chidambaram as finance minister has been lauded for so-called reforms, but increasing FII investment limits in debt, or allowing FDI in retail or aviation is hardly reform. They are intended to rescue bankrupt airlines and a bankrupt economy where the CAD was headed for a new record. Without these changes, the Rupee was crashing, so, these are survival tactics, not reforms.
The Current Account Deficit
In recent years, the fiscal condition of the government has worsened. With growth slowing, government tax revenues stagnant as a fraction of GDP, and spending high, fiscal deficits remain high. At the same time, private consumption, especially in rural areas, is growing strongly on the back of rising incomes, strong credit growth, and continuing government transfers and subsidies.
This has led to a large gap between savings and investment. The worsening in public finance has diminished savings. The gap between savings and investment is the amount of capital that has to be imported. This is the current account deficit. We have a capital shortfall within India, so we are importing capital. And in these conditions, if there is even a short hiccup in capital inflows (as appeared when the GoI proposed to modify the Mauritius route, and more generally with the problems of governance), it yielded sharp Rupee depreciation.
We import a lot of capital; government policy actions interrupt that flow of capital; and the Rupee depreciates. This is not mis-behaviour of the financial system. The system is not malfunctioning; it is behaving as it should.
Inflation: The Mother of All Evil
Inflation has remained in the uncomforting zone for RBI hovering around 9-10% for almost two years now. Even inflation after Dec-11 is expected to ease mainly because of base-effect but the fact is that, inflation still remains high with core inflation itself around 8% levels. It is important to recall that the episode of 2007-08 when despite high inflation and high interest rates, capital inflows were abundant. This was because markets believed this inflation is temporary. Even this time, investors felt the same as capital inflows resumed quickly as India recovered from the global crisis. However, as inflation remained persistent and became a more structural issue, investors reversed their expectations on Indian economy.
India was receiving capital inflows even amidst continued global uncertainty in 2009-11 as its domestic outlook was positive. With domestic outlook also turning negative, Rupee depreciation was a natural outcome. Depreciation leads to imports becoming costlier which is a worry for India as it meets most of its oil demand via imports. Apart from oil, prices of other imported commodities like metals, gold etc. also seen rising and pushing overall inflation higher. Even after global oil and gold prices declined, the Indian consumers are not benefitting that much as Rupee depreciation is negating the impact. Inflation was expected to decline from Dec-11 onwards but Rupee depreciation has played a spoilsport.
RBI’s job is to fight inflation. RBI must work to deliver year-on-year CPI inflation (a.k.a. `headline inflation’) of 4–5%. When tradeables become costlier, domestic CPI inflation goes up. So the Rupee depreciation has made RBI’s job harder.
Some Other Factors
Apart from difficulty in capital inflows & inflation, Indian economy prospects have declined sharply. It has been a shocking turnaround of events for Indian economy. Both foreign and domestic investors have become jittery in the last one year or so because of following reasons:
- Persistent fiscal deficits: The fiscal deficits continue to remain high. The government projected a fiscal deficit target of 5.1% for 2012-13 but later revised it to 5.3% and this too is likely to be much higher on account of higher subsidies.
- Deteriorating CAD: Current Account Deficit for the 3rd quarter of the 2012-13 soared to the record high of 6.7% of the GDP against 4.4% for corresponding quarter of 2011-12. CAD for Oct-Dec quarter widened to $32 billion from $20 billion in the same corresponding quarter of the previous financial year.
- Lack of reforms: There have been very few meaningful reforms in the last few years in Indian economy. Moreover, the policies seem to be getting increasingly populist. The government wanted to reverse this perception and announced FDI in retail but had to hold back amidst huge furor from both opposition and allies. This has further made investors negative over the Indian economy. As FII inflows are going to be difficult given the uncertain global conditions, the focus has to be on FDI.
- Continued Global uncertainty: This is an obvious point with global economy continuing to remain in a highly uncertain zone. This has led to pressure on most currencies against the US Dollar.
All these reasons together making it tough for the Rupee to appreciate or even sustain against USD.
A Vicious Cycle
Growing Indian economy has led to widening of current account deficit as imports of both oil and non-oil have risen. Despite dramatic rise in software exports, current account deficits have remained elevated. Apart from rising CAD, financing CAD has also been seen as a concern as most of these capital inflows are short-term in nature. Boosting exports and looking for more stable longer term foreign inflows have been suggested as ways to alleviate concerns on current account deficit. The exports have risen but so have prices of crude oil leading to further widening of current account deficit.
As far as policy signals concerned, the situation is more chaotic. While balancing current deficit by attracting foreign funds could be a solution, it is easier said than done. A slew of corporate scandals and inaction on policy and reform front is keeping foreign investors at bay. Forget inflows of foreign funds, Indian markets are witnessing selling pressure and forex reserves are falling. Unless the Government bites the bullet and goes for economic reforms, hardly any strategy is likely to bear stable results. An action is long due with regards to reforms on subsidies, taxation, state run companies and increasing transparency and accountability. Anything less will amount of piecemeal intervention that might just smooth the fall but not avert it.
The Possible Solution
We got into this mess because of inappropriate fiscal and monetary policy. We need to solve these — monetary policy must get back to the business of delivering low and stable inflation, we have to fight inflation until we see y-o-y headline inflation going to the 4–5% range. Alongside this, fiscal policy needs to correct itself. Each of these has a clear direction to move in, and movement on any one is valuable regardless of what the other does.
There are five sensible paths government can take, in this situation:
- We need to see that at heart, this is a problem of macroeconomics. The root cause of the current account deficit is the fiscal deficit. If we want a lower CAD, we need a lower fiscal deficit.
- To ensure the smooth capital flow into the country, we should not spook foreign investors. We should bring certainty about taxation to foreign investors, and resist the temptation to levy new retrospective claims.
- We should not interfere with the de-facto residence-based taxation framework which India is giving foreign investors, as long as they come through Mauritius. This policy framework is, in fact, in India’s best interests.
- Deeper problems about the loss of confidence of foreign investors, owing to governance problems, need to be solved by strengthening governance. There is no quick fix other than improving governance.
- Efforts have been made to invite FDI but much more needs to be done especially after the holdback of retail FDI and recent criticisms of policy paralysis. We should open up more to FDI where feasible, because FDI is a safer form of financing. Without a more stable source of capital inflows, Rupee is expected to remain highly volatile shifting gears from an appreciating currency outlook to depreciating reality in quick time.
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