Rupee fall | Not a real crisis, but policy choices are limited as of now

The depreciating rupee has been a matter of concern in recent times. We raise some questions in this context.

How did we land up here?

The rupee depreciation can be traced to the worsening balance of payment (BoP) situation. In particular, the trade gap has grown rapidly since July 2011 when export growth slowed down below import growth. The invisibles surplus and capital flows have not been growing for three-four years, leaving the trade gap open, resulting in BoP deficit in the third quarter of FY12.

Does it look like a crisis?

Yes, but not quite so. The rupee has lost a quarter of its value since July 2011 and the current account deficit-growth domestic product (CAD-GDP) ratio is at 4%—close to the levels seen in countries affected by the East Asian crisis and higher than the 3% level of crisis hit India of 1991. However, there are important differences—import cover, external debt to GDP and debt service ratio are at more comfortable levels now.

Also See | Does it look like a crisis? (Graphic)

What’s left with India?

India has ammunition left to deal with any unfolding crisis. First, its formidable forex reserves are adequate by any definition of adequacy.

Second, is the proven ability of Indian manufacturing to withstand perhaps one of the most drastic tariff cuts in the last two decades (twice that of China).

Third, India’s ability to absorb shocks has increased in a globalized world, where private autonomous capital flows act as a countervailing force to weaknesses on trade account.

Fourth, a much higher stake of foreigners, with cumulative value of foreign direct investment (FDI) and foreign institutional investment (FII) exceeding 35% of the GDP, when sensitized with a 10% compounded annual growth rate.

Finally, as luck has it, flows between FDI and FII have altered, keeping overall capital inflows stable.

What can authorities do?

Policy choices are limited at this juncture. While allowing greater volatility in recent episodes, Reserve Bank of India concentrated on relaxing capital controls, while discouraging speculation through administrative measures. Here are the policy dilemmas: while depreciation helps to restore trade balance, it complicates capital flows; moreover, intervention has consequences on liquidity and conduct of monetary policy; on its part, the government needs to come up with an appropriate trade policy and pacts to correct the trade gap.

Edited excerpts from a report by Motilal Oswal. Your comments are welcome at mintmoney@livemint.com.

Graphic by Paras Jain/Mint

Also See | The rupee saga (Full Coverage)