Rupee concerns

FOR the last couple of months, the sliding rupee has created consternation among many in the Indian economy. In the second week of June it came close to breaching the psychological barrier of Rs.60 to the dollar, and there is fear that even this may not be a real bottoming out for its value.

Of course, those who are directly affected by the lower value of the rupee—such as importers, those wishing to travel abroad or spend on foreign education, and so on—are concerned. But the rupee’s decline affects everyone in the economy because it feeds directly and indirectly into general inflation, which is a continuing problem even as output growth decelerates, and therefore hits common people hard.

The Finance Ministry has argued that this sharp decline in the rupee is “no reason to panic”. Its representatives have suggested that this is happening because most currencies have depreciated relative to the U.S. dollar ever since Ben Bernanke, the head of the United States Federal Reserve, indicated a possible decline in the monetary policy of “quantitative easing” that had encouraged capital to move away from the U.S. in search of higher returns in other currency assets. In this argument, the rupee has supposedly been behaving like most other currencies, especially those of the emerging markets, as investors bring their flows of hot money back to the U.S. economy.

But this is simply not true. First of all, the rupee had declined even when the U.S. monetary policy was at its most lax and when countries such as Brazil had complained about the currency wars generated by the U.S. quantitative easing.

More significantly, as the chart (on page 45) indicates, the rupee’s recent decline has been against all the major currencies, not just the U.S. dollar—and, in fact, the decline has been sharper relative to the British pound and the Japanese yen. In the recent past the Indian rupee has depreciated faster than the currencies of most other emerging markets and is the worst performer among major Asian currencies.

The past two months have accelerated a medium-term decline in the rupee that has been in progress for around two years now. Between April 2011 and April 2013, the rupee lost nearly one-third of its value vis a vis the U.S. dollar. In trade-weighted terms (relative to the currencies of India’s important trading partners), the decline in value of the rupee has been less, but still significant at around 12 per cent. Since domestic inflation in India has continued to be higher than in many other countries, the real depreciation has been less, at around 7.5 per cent, but still notable.

Worsening deficits What explains this decline in the external value of the rupee? Despite what the Finance Ministry claims, this is not the result of global forces or U.S. monetary policy, but of domestic economic mismanagement. Indeed, in a way it is surprising that it did not happen sooner. Most of India’s balance of payments indicators are extremely fragile and the economy has looked vulnerable for some time now. The current account deficit is at the historically high level of around 5.5 per cent of gross domestic product (GDP) while the trade deficit is even larger at around 7 per cent of GDP.

Further, recent trends indicate a significant worsening of both trade and current accounts. Both exports and imports actually declined in 2012-13 compared with the previous year, but even so the trade deficit still increased by nearly 4 per cent, or more than $7 billion. In April 2013, exports were 2 per cent higher than in April 2012—but imports were 11 per cent higher and non-oil imports were 15 per cent more. So the trade deficit increased by more than 26 per cent in April 2013 compared with the previous year (Finance Ministry, Monthly Economic Report for April 2013).

Gold imports A significant part of the growing imports is accounted for by gold imports, which have been ballooning in recent years. (Not for nothing did John Maynard Keynes refer to India as “that sink for precious metals” nearly a century ago…) It is surprising that the government took so long to raise the import duty on gold, and that it has raised it so little, despite the hugely detrimental impact such imports are having on the economy. Meanwhile, net invisibles have been declining, as there are larger outflows because of profit and interest repatriation and various service payments for travel and reduced inflows related to the global slowdown. So the surplus on invisibles is even less able to counterbalance the merchandise trade deficit.

And these large trade and current account deficits are increasingly financed by hot money flows, which are obviously likely to leave whenever problems loom. Departing flows of portfolio capital are said to be associated with the most recent decline in the rupee (and the associated fall in the stock market) but it could just as easily be—and may well be in future—the reduction in external commercial borrowing or the decline in foreign direct investment (FDI) in the form of private equity.

But this generates a chicken-and-egg problem. Since imports are now such a significant part of India’s economy, the fall in the nominal value of the rupee generates inflationary pressures that necessarily add to inflation. So the nominal devaluation of the exchange rate need not generate any positive effect on the trade account because of its impact on prices. And a continued deterioration of the current account can then have a further depressing effect on expectations, generating further movement of capital out of the country and further devaluation.

Domestic oil prices One of the more obvious reasons why the current depreciation is not to be welcomed is the effect on domestic living standards. There are several ways in which the falling rupee immediately has an inflationary impact, one of the most important of which is the price of energy. Since the misguided decontrol of oil prices, it is not only the globally traded price of fuel but also the exchange rate that determines domestic oil prices. Not surprisingly, the second week of June, therefore, also witnessed an increase in domestic oil prices, the third such increase in a few weeks. Since fuel is a universal intermediate, it enters into all other prices directly in production costs and also by affecting transport costs. So we can expect an additional round of accelerated inflation within a few months.

Other industries have also become increasingly import-intensive, which means that they too are immediately affected by rising cost pressures consequent on a devaluation. Both durable consumer goods such as automobiles, white goods and electronic items and non-durable goods such as soaps and toiletries are all likely to become more expensive. And, of course, food inflation—the most worrying aspect of recent price movements—is likely to go up as a result as well.

What is more, the increasing costs of imports can also affect exports, thereby wiping out any global cost advantage accruing from the devaluation. For example, important export sectors such as gems and jewellery, automobiles, machinery and chemicals are all very import-dependent, and their rising costs could nullify the impact of the devaluation on their ability to sell more cheaply in export markets. This is made worse by the fact that in the current depressed global trade context, buyers are able to renegotiate contracts once the exchange rate has changed. Indeed, many global buyers even in sectors such as garments and leather goods now insist on contracts and invoicing in rupee terms. This allows them to benefit completely from rupee depreciation, while the local producers are forced to bear the rising domestic costs. This means that the falling rupee need not generate any significant increase in exports as may be hoped.

So clearly, the sliding rupee should be a major concern for everyone in the country. It is surprising that those who should be most concerned of all—the policy makers in charge of managing the economy—seem to be the ones who are the least bothered by this.