Letting rupee fall is the best option

The rupee has fallen by more than 13% against the dollar since the beginning of 2018, becoming the worst performing Asian currency this year. Other badly hit emerging market currencies are the Argentine peso (-52%), Turkish lira (-40%) and the Indonesian rupiah (-9%). The rupee’s worst performing status in Asia basically remains the same even if we take a much longer time span.

Since December 2007, the percentage change in currency values against the dollar are (as per Bloomberg data): Chinese yuan (+6.4%), Taiwan dollar (+5.2%), Singapore dollar (+4.7%), Thai baht (+2.8%), Hong Kong dollar (-0.6%), South Korean won (-16.9%), Malaysian ringgit (-20.1%), Philippine peso (-23.5%), Indonesian rupiah (-36.8%), Indian rupee (-45.5%). Evidently, the causes are not entirely short-term or due to external factors alone.

What are the proximate causes of the recent slide? Among the immediate triggers, one would first point to the sharply rising dollar price of petro products (mainly due to cut in supply of crude to world market from Iran because of US sanctions and, more generally, the production cut by OPEC and Russia) and hence the hike in the import bill. On the other hand, exports have remained virtually stagnant over the last four years, leading to rising trade and current account deficit (CAD).

We have additional problems in capital account as funds are flowing out of India as part of a more general movement from the emerging markets to dollar-denominated assets. This is in response to higher interest rates already announced by the US Federal Reserve (and even more in the pipeline) and global uncertainty created by worsening macroeconomic and exchange rate situation in several Emerging Market Economies (particularly Turkey and Argentina) along with escalating US-China trade war. In any uncertain global environment, funds flee towards the safe haven of the dollar. The final aggravator is the panic buying by importers, currency speculators and firms rushing to cover unhedged dollar obligations by buying in both spot and forward markets.

How desperate is the current situation? Here, compare 2013 and now – the two most recent episodes of the rupee falling sharply. In 2013, the rupee had gone down by some 23% in the first seven months of that year, CAD was 3.4% of GDP, the fiscal deficit was 4.8% of GDP, foreign exchange reserves were around $250 billion and the average global price of crude oil was touching $110.

In 2018, rupee has fallen 13% so far, CAD is yet to touch 2% of GDP, fiscal deficit is around 3.5% of GDP, foreign exchange reserves (after some recent depletion due to RBI intervention to support rupee) are hovering around $380 billion and the average global price of crude oil is still below $80. In addition, the economy was slowing down in 2013 while growth is clearly picking up at this time in 2018. The average Consumer Price Inflation in 2013 was around 10% as against below 5% in 2018. Clearly, the situation now is much less desperate than in 2013.

In favour of fall

Even so, we should not lose sight of several more fundamental considerations. Many analysts believe that over time, the rupee became overvalued (mainly because of higher inflation rates in India as well as lingering disadvantages originating from less efficient infrastructure, land, labour and capital markets relative to some of its trade competitors), and needs to be offset by appropriate nominal depreciation.

Export subsidies in whatever form, apart from being WTO-incompatible, are being increasingly challenged by the US under Donald Trump. We are much too dependent on oil imports (around 80% of domestic consumption). Selective import duties to cut imports of goods like consumer electronics and telecom equipment (another item of rising imports) run the risk of being hijacked by lobbies to plead for higher import duties on other items.

Hiking duty on gold imports encourages smuggling and diversion of imported gold meant for exports to more lucrative domestic market through ‘fake’ exports of jewel-
lery. Under such circumstances, depreciation of the rupee, which is equivalent of a uniform import duty plus export subsidy on all goods and services (but is WTO-compatible), can kill several birds with one stone.

Hence, most economists are in favour of letting the rupee fall as quickly as possible to find a new equilibrium level. If delayed, speculators would take advantage by buying dollars from the market now and selling later at higher rates at the expense of the RBI. Even China, with more than $3 trillion in reserves, allowed the yuan to fall in the face of capital flight.

Our war chest of $380 billion forex reserve should be scrupulously preserved, specially as a large part of our reserves are borrowed reserves rather than earned through current account surplus (as in China). In addition, maintaining macro stability by sticking to fiscal deficit target is a must. Otherwise, global portfolio managers (prompted by international credit rating agencies) will take more money out of India, worsening the Balance of Payment and exchange rate situations.

The recently announced measures to stem the fall in rupee, like easing terms of short-term external borrowing and tax concessions on rupee-denominated bonds sold abroad, may induce some short-term capital inflows but will increase external vulnerability in the longer term, creating bigger troubles in the not-too-distant future.

Cutting “non-essential imports”, apart from running the risk of violating WTO rules and hence inviting retaliation by others, would take time to produce an impact. Reducing oil import dependence by developing use of alternative energy sources and exploring new oil and gas discovery at home is always desirable but would have been done anyway if it were so easy. Thus, in the short run, we have no option but to let the rupee bear the brunt of adjustment to cope with evolving realities at home and abroad.

Alongside, our mindset needs to accept that the exchange rate is like any other price determined by demand and supply and should not be linked to “national honour”.

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