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Wednesday, December 21, 2011

Freely Falling Rupee: The Winter of Our Discontent!

In the recent past, the rupee has reached its lowest by quoting 53.40 to a dollar on December 13th , 2011. Indeed the downfall has been 21% since August 2011. It is generally believed that a cluster of both external and internal causes are responsible for such a sharp fall, that too within a short period. The prime mover is the sovereign debt crisis in EU that has led to the sharp fall in the value of the euro against—by around 9%—the dollar, which simultaneously caused the rupee too to fall against the dollar; of course, the fall of the rupee has far exceeded that of the euro against the dollar. 

As is being felt by many pundits, the underlying cause for the weakening of currencies against the dollar is the weakening global environment and credit markets that are causing retraction of investments from all the emerging markets to safer havens. Of course, it is to be admitted that India has had more of depreciation than the others and much of it could be attributed to the government’s inaction in pursuing basic reforms that could have made the country more investor-friendly and thereby brought more investment.  Besides no reforms, the ongoing internal squabbles on corruption and its governance have also impacted the overall investment climate in the country. 

There are also a few other internal reasons for such a steep fall of the rupee which merit consideration here: the deteriorating current account deficit, which currently stands at 3% of GDP, is likely to go up, as the oil imports are increasing both in volume and cost, while exports are falling; and capital flight from the country—from August to now, it is said, the FIIs have sold stocks worth $2.3 bn as against $18 bn they brought into the country during the same period in 2010.

That aside, the recent ruckus in the parliament against FDI in retail business and insurance sector, the falling corporate profits, the data for October month which exhibited a fall in the industrial output index for the first time in 28 months (by 5.1%, much more than the forecast of 0.5- 1% decline), rising fiscal deficit owing to bourgeoning subsidies and falling tax collections have all cumulatively made India a less favorable destination for capital inflows. Over and above all this, the accounting goof-up in reporting the export numbers in excess by about $9 bn does not augur well either.

Obviously, India Inc is pressing for the intervention of the RBI to stem the depreciation of the rupee. It is good that the RBI has not jumped yet at it. Indeed, this demand for arresting depreciation needs to be looked at from the very macroeconomic fundamentals of the country, for the managers of exchange rate cannot afford to ignore the basic axioms of exchange rate mechanisms: as the inflation rate in our country is higher relative to the US, rupee has to depreciate against dollar to the extent of inflation rate differential. With the kind of differential that we are having, the rupee perhaps should depreciate even further. Indeed, when measured against the six most traded currencies, the real effective exchange rate looks still higher by 1.5% vis-à-vis what it was in 2009/10, avers The Economic Times.  Which is why the RBI should sit back quietly, letting the rupee find its own rate, for rupee was after all due for correction. 

True, the depreciating rupee will have both positive and negative fallout: on the positive front, it increases competitiveness of our exports, while it could negatively impact the government budget and the balance sheets of corporate that borrowed heavily from global markets. Yet, it is not technically sound for the RBI to intervene in the market only when rupee depreciates, while not intervening when it was appreciating.

There is yet another reason why the RBI should not intervene in the market particularly at this juncture: the forex reserve that India is holding is not out of its current account surplus but more out of capital inflows. Perhaps, India is the only emerging market economy in Asia that is persistently experiencing current account deficit. And the experience of Thai in 1997 is still fresh in memory: selling dollars and mopping up of Thai baht by directly intervening in the market could not stall its fall, while the reserves depleted to zero.

That said, it doesn’t mean that the RBI should keep quiet while rupee is falling freely, leaving imports panicky. It should initiate measures to eliminate the scope for speculation in the market and work towards arresting volatility in the currency market. And that’s what the RBI did by announcing a set of qualitative measures such as reduced net overnight open positions for currency traders, disallowing cancellation and re-booking of forward contracts, compelling corporate to take/give delivery of dollar they buy/sell, etc. Though these measures are likely to create illiquidity in the market, they are sure to hit speculation. The other measures such as raising the ceiling on interest rate on ECBs and FCNR/NRE deposits are likely to increase the capital inflows, of course, as long as the going is good.  

Moving on further, it is the government which must do more than what it is currently doing to arrest the free fall of the rupee. The government should come out of its gridlock and act towards introduction of new policies that augur well for governance of economic growth. It should decontrol diesel prices to cut consumption/imports, plus reduce the burden of fiscal deficit. Most importantly, it should support the monetary policy initiatives of the RBI by acting in tandem with it. In the meanwhile, it makes great sense for the corporate not to act wild.
GRK Murty


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