A battered rupee

The falling rupee is a part of the long-due adjustment process to bring back competitiveness to the Indian economy.

The Indian rupee, after breaking the Rs 60 (to a dollar) barrier is now heading towards 65, despite a series of emergency measures (such as raising short term interest rates and squeezing liquidity from banks to discourage financing of speculative activity against rupee, raising import duty on gold and non-essential imports, reducing limits on foreign investment by Indian companies and outward remittances by Indian residents) announced by RBI and the finance minister to stem the slide.

How to explain this continuing downward journey of  the rupee?

The exchange rate is determined by the demand and supply of dollars. One approach would be to focus on the rising current account deficit (CAD) – at around 4.8 per cent of GDP, much above a sustainable level of  around 2 per cent --  which implies a growing demand-supply gap for dollars. Even this would not have been a problem for the rupee-dollar exchange rate if  the supply of dollars from (net) capital inflows from abroad were enough to finance the CAD. In fact, rupee remained stable for a long time, despite a high CAD, so long as foreign investors were willing to bring in dollars to invest in the high-growth Indian market. The problem for capital investment in India started mainly after the confirmed slowdown in the Indian economy which has made equity investment in India (even by Indian companies) less profitable. This trend got further accentuated after the US Fed indicated a gradual ending of monetary stimulus which started to raise interest rates in USA that made investment in Indian bonds less attractive. Thus, both FDI and FII money began to shun India, reducing the supply of dollars, pushing dollar up and rupee down.

Another approach would be to look at the much higher inflation rate in India relative to US, EU and some of our major competitors. So, eventually the rupee had to fall in order for Indian goods and services to maintain their international price competitiveness. Otherwise the trade (and the current account) deficit would go on mounting uncorrected. So, falling rupee is a part of the long-due adjustment process to bring back competitiveness to the economy. Either the rupee has to fall or the inflation rate has to be brought down. 

Some would like to emphasise the macroeconomic equation which says that CAD is equal to the gap between national output and expenditure. Thus, overspending is primarily responsible for the spillover into an unsustainably high CAD (even expenditures on domestically produced goods have import content, direct and indirect) and a rising fiscal deficit is the major culprit behind this national overspending. Looked at this way, the basic solution has to come from cutting down the burgeoning fiscal deficit.

Alternative assets

Yet others would like to focus on the specific sectoral issues. Rising gold imports is a new contributory factor to rising CAD. This is because high inflation is increasing the attractiveness of gold relative to financial instruments as alternative assets. The burden of oil imports is getting heavier as a result of rising international prices of petro products (beyond India’s control). Import of coal is going up (even though we have one of the biggest deposits of coal in the world) due to the inefficiency of coal mining (CIL monopoly) and virtual stoppage of work at captive coal mines allotted to various parties under the cloud of corruption charges.

Exports of iron and other minerals have suffered a decline due to disruption to all mining activities following allegations of rampant illegal mining. Slowdown in western economies is hurting our exports, specially in IT sector (again beyond India’s control). Big investment projects in steel, aluminium, power and  roads have remained stalled for years, thanks to lingering problems in land acquisition, securing environment and forests clearances and policy uncertainties. Slowing demand and rising cost of inputs are acting as further dampeners to the investment climate. All these are scaring away both domestic and foreign investors to invest in India, causing a net outflow of dollars from India, pushing rupee down.

If we combine all these approaches, the possible steps to stem the falling rupee will have to be on multiple fronts. We need  to control inflation (if primarily a food inflation, by improving productivity, storage and distribution systems in agriculture), cut fiscal deficit and  improve the investment climate by clearing stalled investment projects, ending policy uncertainties, removing bottlenecks in coal, power, oil, gas and mining sectors and dispelling  the cloud of corruption and uncertainty over the allocation of natural resources like land, spectrum, coal and natural gas with putting in place open competitive bidding and independent regulators. 

But these will take time, even if serious efforts are made now. Meanwhile, several options are being considered in policy circles to increase the supply of dollars and create a breathing space. Approaching the IMF for a standby loan is an option which would immediately provide some additional foreign exchange reserves to finance CAD. But the political risk of approaching the IMF and  its resemblance to the 1991 crisis make it a (politically) unattractive option. The issue of GOI (sovereign) bonds in foreign exchange at a time of economic crisis (hence at higher interest rates than otherwise) and the additional debt servicing cost in future budgets would not be favoured by the finance ministry.

Consequently, the more likely options are the issue of quasi-sovereign bonds by public sector financial institutions, encouraging Indian companies to go for external commercial borrowing (Q: why should they do it in a bad investment climate?) and attracting NRI funds by offering higher interest rates. Any of these options is fraught with the danger that the present problem may be  postponed by creating an unsustainable debt servicing burden a few years hence while reducing the immediate urgency to go for unpopular structural reforms, specially in an election year.

(The author is a former professor of economics, IIM, Calcutta)