In 2008, India’s nominal trade-weighted exchange rate has depreciated by more than 12% whereas that of the Chinese currency has appreciated by nearly 10% (source: Bank for International Settlements). Whether by choice or default, the Chinese currency is headed in the right direction whereas the Indian rupee is headed in the wrong direction.
In a recent editorial, this newspaper had correctly identified the danger lurking in the balance of payments (BoP) statistics for the first quarter of the current fiscal year released by the Reserve Bank of India on 30 September. The editorial concluded with an advice to keep oil consumption under control so that the import bill and trade deficit would be contained. It should have made a broader point. Examining India’s the first quarter BoP statistics leads one to the conclusion that the dollar would continue to head north against the rupee while the Indian stock market is headed south.
External deficit or surplus is a mirror image of internal savings. The current account balance is the same as internal savings—investment balance. India’s household savings rate peaked in 2003-04. The corporate savings rate doubled between 2002-03 and 2006-07. Public sector savings rose, too, due to buoyant tax revenues spurred by the 9% growth in the gross domestic product (GDP). It appears that the savings rate, although on a rising trend over the long term, reached a short-term plateau in 2006-07. Hence, India’s old scourge—the current account deficit —is back.
If the current account deficit is to be arrested, it is important that domestic savings rises. It is better and efficient for India now if the government contributed to this savings increment rather than the private sector.
Paying no heed to the onset of the global credit crunch at the beginning of this year, the government opted for a profligate Budget for 2008-09. Even with the passage of the bailout plan in the US Congress, the severity of the credit crunch is unlikely to abate by much. Internationally, the dollar is in short supply due to the shrinking of the US current account deficit and due to the demand for dollars by foreign institutions whose dollar assets have dropped in value but whose dollar obligations have not.
Under these circumstances, even a modest current account deficit would continue to exert pressure on the rupee to weaken and potentially turn that into a rout if other factors—political and economic—turn unfavourable, too. It is one thing to defend an exchange rate with ample foreign exchange reserves but another thing to reinforce it with fundamental soundness. India can do the former but it must opt for the latter.
Having grown at an unsustainable rate over the last five years, the global economy is likely to grow at a sub-par rate over the next several years. With external demand thus likely subdued, there is little to be gained by keeping the rupee weak. In any case, the sensitivity of India’s exports to the rupee exchange rate is smaller than that of its imports to domestic growth. Further, India’s exports contribute little to GDP compared with domestic demand factors.
Ensuring domestic demand stays strong requires lower domestic interest rates. Structurally, lower interest rates require the fiscal deficit to decline credibly. India’s domestic debt is 90%-plus of GDP. Even if its external debt is much smaller, domestic debt is a potential inflation risk and an overhang on the currency. That deters foreign investors, especially when they are battling for survival on their home turf.
The government has to urgently embark on reducing public spending, abolish guaranteed returns on employee provident funds and resume privatization. This would lower government borrowing and domestic interest rates and restore confidence in the currency, while raising the domestic savings rate. Lower interest rates would then crowd in the needed investment from the private sector. It would greatly help, too, if the government worked on removing further impediments that have contributed to a massive underachievement of targeted generation of power and production of steel, as Pradip Baijal pointed out in the Business Standard recently.
The present government missed a fine opportunity to allow the market to set the retail price of petroleum products when crude oil was at a peak. Had it done so, retail prices could be dropping now bringing cheer to households. It is still not too late.
Setting the fiscal house in order and strengthening the fundamental underpinnings of the rupee would be a good legacy to leave for our economist-Prime Minister. Chances of this happening if a third-front government came to power are nil. Hence, the Bharatiya Janata Party (BJP), leaving its cussedness behind, must support it if the United Progressive Alliance (UPA) government takes such an initiative. Better still, if the BJP were proactive on this. It can make up for the ground it lost to the UPA on the nuclear deal.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org