Discussions in policy circles and the financial market is being dominated by the sliding rupee. Though the rupee was witnessing downside pressure for a while, concerns have mounted a great deal ever since the US Federal Reserve laid out a fairly clear path of action to scale back its asset purchase programme. The slide in the rupee and the changing dynamics of the global financial market raise a number of fundamental questions on the state of the economy and the stance of the central bank which needs to be debated.
The US central bank will start reducing the quantum of asset purchase later this year and, if all goes as expected, it will stop pumping money into the system by the middle of next year. The Federal Reserve is currently buying assets worth $85 billion from the marketplace. Though the US central bank is not expected to raise interest rates in the foreseeable future, the reduced injection of cash into the system will raise the cost of money in the world’s largest economy and, as the bond yields rise, the wild search for returns will contract. Differently put, the inflow to emerging markets will come down. Adjusting to emerging realities, the rupee has lost 7% in the last one month and is hovering around the psychological market of Rs.60 against the dollar. The fear is that the shift in expectations in the global financial system will reduce the flow of money towards Indian shores, and with its very high dependence on foreign flow to fund the current account deficit, the rupee will melt further. Therefore, even if we discard a threat of a large-scale capital outflow—just for the sake of comfort till it lasts—both the economic management and the life in the financial market will be extremely difficult.
The worry over the falling rupee is not difficult to understand. Lower value of rupee straightaway cuts the purchasing power of India as a consumer and raises cost for India as a producer. Large amount of dollar debt on the books of corporate India will affect earnings, as more money in local currency would be required to pay foreign debt. Lower earnings will affect the performance in the stock market and, to complete the vicious cycle, will reduce incentive for foreign investors to invest in India, resulting in further depreciation of the rupee.
While the risks of a sharp depreciation are well known, the question is: how low can the rupee go before things starts to stabilize? The government of India believes that the rupee has lost more then what the fundamentals warrant. However, the view emerging from the discussion in the media suggests that things will get much worse before it can stabilize. Economist S.S. Tarapore, for example, has been arguing that the rupee should be at 70 against the dollar. In a recent article in The Hindu Business Line, Tarapore wrote: “While most observers are arguing how soon the rate will move to $1=Rs.60, the correct question is how soon it will move to Rs.70, which indeed is the appropriate rate given the inflation rate differentials.” Tarapore is not alone and the view is widely shared. Jaimini Bhagwati, an Indian diplomat and an expert in finance, has put numbers into perspective. “The rupee depreciated sharply by 21.9% in the 14 months between April 2012 and 18 June 2013, and the total depreciation from April 2008 to June 2013 was 26.6% (4.7+21.9). In recent years, consumer price inflation in India was at least 6% more than in the US and this difference in inflation compounded over five years amounts to 34%. By this metric, in real terms, the rupee has appreciated by 7.4% (34-26.6) in the last five years,” Bhagwati highlighted in his recent column in the Business Standard. Charts and the mood in the financial market are not looking for a rebound either. Jamal Mecklai, an expert in the currency market, in his column in The Indian Express noted after the announcement by the Federal Reserve: “On 6 June, my technical team sent me a chart looking for a bottom of 62-plus; as a (relatively) lay person, I would have to say, now that we’ve (more or less) seen 60, the next major stop would have to be 65.”
The rupee will not only be affected by the internal macroeconomic weakness of India, but also because of the rising strength of the dollar. However, the weakness in the rupee should not be seen in isolation and only as a consequence of withdrawal by the Federal Reserve. The Indian rupee, despite record inflow of foreign capital over the years, has lost roughly half of its value since the beginning of 2008 (see chart). Clearly, the story has more angles than just accounting for capital inflow and outflow. It reflects the increasing weakness and the loss of competitiveness of the Indian economy.
This raises another important question—should the central bank always allow market forces to discover the value of the currency? Should it not intervene in the market to build some reserves as insurance for future needs? The standard stance that economists take on the issue is that the central bank should stay away from the currency market. However, if this was followed, the country would have had no foreign currency reserves. It is even hard to imagine what would have been the state of currency market today in such a scenario. These are important issues and needs to be debated in order to attain greater stability in the future. This column does not have answers to these complex questions, but is it not difficult to argue that the economy and the currency could have been managed better.