The steep, 22% depreciation of the rupee since August 2011 has set off the inevitable comparison with the 1991 devaluation. Markets participants judge the currency correction to be near complete, although volatility around current levels is likely. Questions about macroeconomic adjustments that devaluation triggers naturally surface in this context. What is the likely pattern of correction? How long will adjustment take? And, perhaps the most important, will corrective macroeconomic policies follow through to correct the imbalances and return growth on track?
The two deficits – current account and fiscal – are at the centre of this fine-tuning. Will the rupee’s fall narrow the large trade gap? That wasn’t the case last quarter at least. Indeed, the positive association between the real effective exchange rate (REER) and the trade gap, whereby an increase in export competitiveness narrows the trade deficit, is simply not observed from mid-2010.
Since then, the positive exchange rate-trade balance relationship reverses and a real depreciation actually corresponds to a widening trade deficit. Possibly, this is due to high inflation and oil prices; inflation has been exceptionally high (in double-digits mostly) in this period while oil prices jumped $34 per barrel (Indian basket) in the year to April 2011. Since then however, oil prices have receded, only going up in the first quarter of 2012. But the trade deficit continues to widen nonetheless, raising questions about the extent of external adjustment that will follow in the near future. If the weak performance of the trade balance in recent times is indeed due to an increase in domestic production costs (also an increase in domestic export price, which erodes competitiveness) this could offset any gains from depreciation.
Thus how effective an external sector approach can be in overhauling the current account position remains to be seen? Inflation hasn’t really come off; the halving of gold imports in Jan-March 2012 is attributed to tax uncertainty, so its inflation-hedge appeal may return; while oil import demand remains intact.
This brings fiscal policy into focus from where much of the inflation persistence originates. Low revenue buoyancy due to sub-trend growth is pushing borrowings-financed deficits even higher, leaving little space for private capital expenditure. That leaves the only scope of fiscal correction as subsidy-reduction from passing on the crude oil import prices on to consumers. The Finance Minister has braced up for ‘austerity measures’ but belt-tightening through domestic fuel price adjustments can happen only if political partners agree. Containing the fiscal deficit remains iffy, therefore. It’s also anybody’s guess as to how prolonged macroeconomic adjustment could be in this context.
Fortune may smile if global oil prices really slide or an advanced country central bank plugs for some more quantitative easing. One could ride upon such wishful thinking except that it’s no substitute for the hard job at hand.
Renu Kohli is a New Delhi-based macroeconomist; she is a former staff member of the International Monetary Fund and Reserve Bank of India.