India recorded a trade deficit of $20 billion in January, one of its highest monthly shortfalls, indicating that challenges on the external front will not subside in a hurry.
Interestingly, the rupee has remained by and large stable in recent months. This trend is a sharp contrast to the nervousness witnessed in mid-2012 when the rupee was almost in free fall. The rupee has gained from Rs.56 per dollar in July to Rs.53/54 now. It has also gained in terms of the real effective exchange rate.
True, a lot has changed on the ground since then, but is that sufficient to alter expectations so dramatically? Alternatively, is the rupee level a real reflection of the fundamentals or is it just the making of a bigger crisis?
Globally, things have changed for the better because of direct or indirect interventions by large central banks such as the US Federal Reserve and the European Central Bank. Consequently, equity markets across the world rose and the stress eased significantly in the debt markets of the troubled euro zone.
For India, while higher readings on the ticker raised investor confidence and market activity, foreign inflows came in handy in supporting the rupee. But all this can change very quickly once again. External finances continue to remain the single biggest source of threat to Indian financial markets—or for that matter to overall financial stability.
The rupee has gained at a time when the last reading on the current account deficit (CAD) was 5.4% of the gross domestic product (GDP) in the second quarter of the current fiscal. CAD is now widely expected to have been in excess of 6% of GDP in the third quarter. To put numbers into perspective, India needs about $80 billion a year to fund the gap on the current account.
Therefore, if the numbers are anything to go by, the rupee should have been depreciating. But that is not the case and the reasons are not very difficult to identify. The developed countries are busy competing with each other in devaluing their currencies and, as a consequence, flooding the world with cheap cash. Some of it is landing on Indian shores as capital flows. Strong capital flows are bridging the gap created by the current account and holding up the rupee. However, this easy money will not last forever, and even if it does for a considerable period, it poses a different set of challenges.
A sudden stop or a slower pace of inflows can quickly turn the tables for the rupee. Though the liquidity in the global financial system is expected to remain comfortable, surprises in fragile economic conditions can emerge anywhere, any time. Tensions in the international financial markets could potentially rise due to slow progress over budget talks in the US, or due to differences in bailing out a country as small as Cyprus in the euro zone.
Even if it is assumed that India will keep borrowing easily by liberalizing the capital account to fund the current account and push currency to higher levels, the idea is being increasingly questioned. The Reserve Bank of India (RBI), so far, has maintained that it will only intervene in the currency market to curb volatility and not to manipulate the exchange rate.
This exchange rate policy is advisable in ideal conditions, but the present conditions are a lot different from those that find mention in the textbooks. The exchange rate policy, therefore, needs a critical examination. Writing in The Hindu Business Line on 24 January, former deputy governor of RBI S.S. Tarapore noted: “With the inflation rate persistently above that in major industrial countries, the rupee is clearly overvalued. Adjusting for inflation rate differentials the present nominal dollar-rupee rate of around $1 = Rs.54 should be closer to $1 = Rs.70. But our macho spirits want an appreciation of the rupee which goes against fundamentals.”
An overvalued currency will continuously increase import dependence of the country and could turn the high CAD into a structural problem, undermining financial stability and growth. Therefore, no matter which way one looks at it, the currency and the external account remains potential source of risk.