JOIN USAnyone with even a vague sense of economics would have seen this coming. It was a matter of when, not if that the rupee would depreciate. An unsustainably large and persistent trade deficit, a large fiscal deficit, sustained high inflation, slow growth – all pointed towards the inevitable.
Root cause analysis would reveal the problem began towards the end of 2008. Fiscal stimulus and monetary easing started that year, almost all of which was directed towards boosting consumption and led to a persistent rise in inflation. Between May 2008 and May 2013, WPI inflation has averaged 7.5 percent and CPI inflation (CPI-IW Index, Source: Labour Bureau) has averaged 10.2 percent. Trade deficit remained unsustainably high, rising about 2.5 times between 2007 and 2012. Monthly trade deficit reached a high of $21 billion in October 2012.
During this period, the rupee depreciated to 60 from 40 to the dollar, a fall of 33 percent (a compound annual growth rate of -7.8 percent). The situation could have corrected itself earlier had the imported price inflation been passed on to consumers. Imports could have come down and trade deficit narrowed as high prices dented demand. Instead, the policy of subsidizing imported energy prices prolonged the pain and kept bloating the trade and fiscal deficits, thereby adding fuel to fire.
The macro environment has been negative for the rupee for years. High inflation and a wide current account deficit had already weakened the surface on which the rupee stood. What prevented a collapse much earlier were robust capital flows, be it loans or investments (FDI and FII) or private transfers and remittances. Investment flows were particularly robust during much of 2012-13, except the first quarter, as global markets were awash with liquidity pumped in by central banks in the U.S., the UK, Europe and Japan at different times.
The problem started when the Bank of Japan refused to increase the stimulus amount and the U.S. Fed hinted at a withdrawal of stimulus (QE). The risk of withdrawal of global liquidity led to FII outflows from Indian equity as well as debt markets. As on June 27, FIIs had withdrawn close to $7 billion from Indian debt since May 22 and $2 billion from equities since June 1. In fact, in terms of total outflows (debt and equity combined), June has so far been the worst month ever, seeing net outflows of approx. 420 billion rupees (up to $7.5 billion) till June 27.
The media is awash with calls on the rupee falling further. Experts have put different targets to the rupee, ranging from 62 to more than 70 in the short- to long-term. I am tempted to have a contrarian approach.
Macros have improved incrementally over the last quarter or so. The current account deficit was much better at 3.6 percent of GDP in the last quarter of 2012-13, as compared to 6.5 percent in the previous quarter. Moreover, people who had an ear to the ground would have known that enquiries had started pouring in from NRIs and Indians working abroad who wished to repatriate or remit money the day the rupee touched 60.
Judging by the panic created the day rupee breached the 60 mark, it seems a short-term bottom might already be in place or is about to shortly. The rupee may fall further and touch 62 levels as predicted by some pundits. But we aren’t in the predicting camp and moreover, another 2-3 percent hardly matters. What one must understand is that after the recent fall, the risk reward has turned in favour of the rupee. It is better to bet for it rather than against it.
The worst in terms of macros might already be behind us. Inflation is likely to stay low (barring a few occasional hiccups) and growth has most likely seen its bottom (though it doesn’t look like recovering sharply in the near term). With gold imports coming down and the rise in imported energy prices being passed on to consumers, the current account deficit should be a lesser worry going forward. The decision to hike domestically produced natural gas prices could be a game-changer as it helps reduce dependence on energy imports and encourages FDI in the medium term.
Apart from full-blown global risk aversion, it is hard to see any other reason for the rupee to depreciate further in the short- to medium-term. We may have seen the worst in terms of macroeconomic fundamentals and the rupee. The future looks less gloomier though. This is not the time to panic and rush for hedging the rupee or buying the greenback.