Risky trade-offs to stabilize the rupee
The steps announced after the economic review speak more of political compulsion than economic logic
Earlier this month, Union finance minister Arun Jaitley argued that there was no need for a knee-jerk reaction to the sharp rupee depreciation since it was driven by global factors. This is true, but only partly so. While global factors have played a major role, they have done so in the context of India’s domestic fundamentals. Nevertheless, there is a gap between Jaitley’s stand then and the measures the government announced at the economic review meet late last week. Opposition pressure on rising fuel prices goes some way towards explaining it. Under the circumstances, the Narendra Modi government would have felt the pressure to be seen to be doing something. But political logic and the economic variety are different beasts.
There is a solid argument to be made that the rupee is still overvalued, looking at the real effective exchange rate. That said, the velocity of the depreciation has consequences for market sentiment and increases stress on foreign debt repayment. Rising fuel prices don’t help, and a widening current account deficit (CAD) will have consequences that go beyond the immediate. The measures announced at the meeting are superficial solutions that also increase vulnerability, however.
The experience of emerging market economies (EMEs) since the 1980s shows the growing importance of capital flows in determining exchange rate movements as against trade flows. The contrast between the 2013 taper tantrum and 2014-15 when the rupee stabilized provides a fine example. The resurgence of foreign institutional investment (FII) inflows by 2014 partly had to do with external conditions, of course; the Federal Reserve’s normalization of monetary policy had been priced in by then. Oil prices had also dropped sharply. But that wasn’t the whole story. The rupee was, by and large, also more stable than its EME peers in 2014-15.
There were a number of reasons for this. The CAD stood at a record 4.8% when the taper tantrum hit. In FY15, it was down to 1.3%. Political stability, the prospect of economic reforms under a then-new government, fiscal consolidation, and consumer price index (CPI) inflation coming under control after running away in 2012 and 2013 all made for sound fundamentals and positive sentiments. This helped boost FIIs—but crucially, it also goosed foreign direct investment (FDI). FDI had slumped over 36% year-on-year in FY13. It grew by 8.37% in FY14, albeit from a low base. In FY15, it spiked sharply, growing by 27.3%.
External conditions today are not as sanguine as they were in 2015. Although Turkey’s increasing interest rates sharply may improve market sentiment somewhat, the EME contagion is far from over. There is also a likelihood that the Fed will hike rates twice more this year, making it the biggest annual tightening in a decade. And with the Iran sanctions about to hit, a possibility of a short-term slowdown in US shale supply and the lack of capex by oil majors over the past few years beginning to bite, oil prices are likely to continue to be unhealthy for the import bill.
All of which is to say that there is a good chance that FIIs will stay volatile. The various measures announced to increase access to foreign debt capital at the meet should be seen in this context. Certainly, if the decision is made to ease external commercial borrowing (ECB) norms, it may boost inflows by up to $8-10 billion as some have estimated. However, more short-term debt is a punt that wagers increased indebtedness against the prospect of an appreciating rupee. If it doesn’t pay off, it will leave manufacturing companies vulnerable. And easing mandatory ECB hedging conditions for infrastructure loans creates significant risks. As G. Mahalingam, then Reserve Bank of India (RBI) executive director, noted in 2015, large corporate forex exposure, when not adequately hedged, “could, in turn, increase vulnerabilities for both local banks and the financial system more broadly. Shocks to interest or exchange rates could generate adverse feedback loops…”.
The sharp spike in CAD in FY18, too, is more reminiscent of 2013 than 2015, although far from as alarming. It is too simplistic to argue that depreciation will boost Indian exports. India’s trade record disproves that, showing that its exports are far more closely linked to global demand than the rupee’s value. That said, the government’s announcements regarding the CAD after the review aren’t particularly encouraging either. Cutting non-essential imports is an old story. The government’s increasing trend towards import substitution is repeating old mistakes. Unlike in 2013 when gold imports were choked, there is no easy target this time. As for boosting exports, there are no quick fixes here. Deep structural changes from infrastructure to trade policy are needed to boost export competitiveness, as well as easing exporters’ goods and services tax woes.
2014-15 showed the importance of sound fundamentals for currency stability and the sticky long-term equity inflows that are more reliable than FII debt capital. This is where the government should be looking. Jaitley’s statement on the weekend that there will be no fiscal profligacy in the run-up to the elections is a welcome signal in this regard. So is the fact that CPI inflation is under control. RBI’s healthy forex reserves mean that there is no need to press the panic button just yet. The Modi government should be very careful about the trade-offs it makes when it expands on the steps announced after the meet.
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