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Wednesday, September 26, 2018

Rupee Drops to a Fresh Low: Challenges Ahead

As August inched towards its end, rupee, opening at 70.69 as against the previous day’s record closing rate of 70.59, fell by 0.21%, and what was more disturbing was: going forward the trend appears to be weak.  And the reasons for such a steep fall are not far off: the heavy month-end demand for dollars from importers, particularly from oil-importers and foreign capital outflows from the capital market, plunged rupee to an all-time low. It all started with the political turmoil in Turkey which impacted its lira vis-à-vis dollar and the contagion spreading to all other emerging market currencies. But it is the rupee that has become the worst performing currency in Asia, depreciating almost by 9% since January. It is our widening current account deficit, which is around 2.5% of GDP for FY 19 that caused continuous shortage of dollar liquidity which is primarily responsible for this fall. 
Of course, the Reserve Bank of India (RBI) has been intervening in the currency market to slowdown the fall of rupee, and in the process, its reserves have indeed come down from an all-time high of $426.88 bn in April 2018 to $400.8 bn for the week ended 17 August. Yet, some dealers opine that its intervention is not matching the kind of rising demand for dollars that the market is witnessing.
As the RBI pointed out, in the days to come, rupee is likely to be impacted by global risk factors such as: one, geopolitical developments in West Asia leading to sharp hike in crude oil prices; two, faster-than-anticipated pace of rate hike by the US Fed; and three, trade-related tensions across the major trading partners such as the US, Eurozone, China, etc., and the resulting volatility in the financial markets. 
That aside, even domestic factors such as the growing cost of the rising import of crude oil owing to rising global prices, lowering of goods and services (GST) rates on a range of consumer goods, the tax cut on small businesses and the relatively high minimum support prices declared by the government for agricultural produce are equally causing concern, for cumulatively they are certain to adversely impact the fiscal position. And, increased fiscal deficit is likely to fuel the inflation further, which in turn will have its own impact on exchange rates.
Here it is in order to recall what Raghuram Rajan, Professor from Chicago University, said at this year’s Jackson Hole get-together of Central bankers. He said that risk is building up again in the system and the trade-wars initiated by the US are potential enough to trigger the vulnerability in the system into a crisis. And, the prevailing global and domestic risk factors that India is facing are likely to expose us to such vulnerabilities.  
As commonsense would dictate, it is the importers who are very displeased with the falling rupee, for it straightaway affects their profitability. But surprisingly, this time round, even exporters are vociferously airing their concern against the depreciating rupee. They lament that in the wake of continuously falling rupee, they are finding it extremely difficult to negotiate a right price with their importers. However, at the same time, citing REER, they also argue that any depreciation of rupee is a move in the right direction, for it makes rupee more competitive among the trading partners. And this, they argue, shall in turn give boost to our exports. But this appears to be a myth, for our exports have indeed grown when the REER has grown. That aside, what exporters need to bear in mind is the impact of domestic inflation likely to be caused by depreciating rupee on the costs of their exports.  
Now, this raises an obvious question: Should the policy makers let the rupee spiral down in this manner? There is no ‘the’ answer, but the prevailing global factors warn us not to fall into the trap of exporters’ arguments. Even otherwise, the REER announced by BIS Board places rupee at 100.39, which means there is no overvaluation of rupee, while the REER of RBI calculated with 2004-05 as the base year against the currencies of China, Hong Kong, the US, Eurozone, Japan and UK currently stood at 123—meaning rupee is overvalued by 23% in relation to these economies. This difference in the estimates of BIS and our RBI demands a fresh debate on the very style of calculation of REER by the RBI.
That being the reality, the way forward is: improving our macroeconomic fundamentals and diversifying our exports. This obviously calls for requisite structural reforms on the lines that the RBI has recently asked for. Introducing short-term measures such as allowing manufacturing firms to avail external commercial borrowing of up to $50 million for one year maturities in place of the existing three-years is certainly a bad idea. For, such measures can only help us tide over the immediate crisis but are sure to create more stress in the future as the short term external debt is already hovering around 42 percent of the total foreign currency loans. Yes, imposing import curbs on non-essential goods is likely to ease to current account deficit. Similarly, government not yielding to the demand for cutting duties on petrol and diesel is in the right direction, for it can reduce demand (?) and certainly pave the way for environmental improvement. And revisiting some of the measures that RBI took in 2013—opening a special swap-window for oil importers and even inviting FCNR deposits with attractive interest rates—is no bad idea at this juncture.
So, in the ultimate analysis, the focus of the policy makers should be on long-term reforms that can improve our current account deficit. And that is what the policy makers should address fast if we wished to stop depreciation of rupee on a long-term basis.


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