Rupee at 60: the options before RBI

The rupee logged its biggest gain in last nine months on Friday, surging some 80 paise to close at 59.39 a dollar, after sinking to its historic low of 60.76 just two days ago. A bouquet of actions—ranging from the government raising natural gas prices from fiscal year 2015 to the Reserve Bank of India (RBI) tweaking the external commercial borrowing norms and small doses of dollar sale—arrested the free fall and recouped part of the recent losses, but it’s no time to celebrate as yet. The local currency will remain vulnerable as long as India’s current account deficit is high.NextMAds

Indeed, the trade gap narrowed to 3.6% of gross domestic product (GDP) in the fourth quarter of fiscal year ended March, pegging the deficit for the year at 4.8% of GDP, lower than the estimated 5%. However, that’s not good enough to stabilize the rupee even if it is marginally undervalued on the basis of the so-called real effective exchange rate (REER), an aspect which Raghuram Rajan, chief economic advisor to the government, has been harping on. REER cannot be the sole measure to decide on the ideal level of the rupee, particularly when the current account deficit is so high. Neither the government nor the RBI can let their guard down on the currency front.

In theory, a weak rupee should help pare the current account deficit as it would boost export earnings, but that is unlikely to happen till the global demand picks up. The rupee depreciation alone will not be able to drive exports. For instance, in calendar year 2011, India’s exports grew 35% and contracted 2.5% in 2012 while the currency depreciated by 14% between 2011 and 2012, as has been pointed out by a recent research report of Standard Chartered Bank.

There are other factors too that have a bearing on exports. The rupee is not the only currency that is depreciating; currencies of other emerging markets with which Indian exporters compete have also been depreciating. So, India does not have a unique advantage over others. Besides, part of the currency deprecation benefit for exporters gets nullified by importers’ clamour for discounts in such a situation. So, in the current context, a weak rupee is not a boost for exports and unlikely to be of great help in shrinking the current account deficit.

On the contrary, it can nullify what the government and the RBI have achieved vis-a-vis the fiscal deficit and inflation. Fiscal deficit in 2013, estimated at 4.9%, is better than what many had expected. India’s wholesale price inflation dropped to a 43-month low of 4.7% in May and retail inflation dropped to 9.31%.

What is more reassuring is that the so-called core inflation, which excludes volatile food and fuel prices, has been coming down rapidly. But a weak local currency will have an adverse impact on both fiscal deficit as well as inflation.

India will have to pay more for oil imports and that will inflate the oil subsidy bill unless the government decides to pass on the entire burden to consumers. It is highly unlikely, particularly when the nation is readying to go to polls next year. Similarly, fertilizer subsidy will also rise. Both will impact the fiscal deficit.sixthMAds

The rupee depreciation will have a bearing on inflation because of the rise in the cost of imports. Analysts are busy calculating the quantum of impact but the right figure will depend on the extent to which companies can absorb the cost themselves and put their profit margins under pressure and by how much the prices can be raised without affecting the demand which in many cases is already low in a slowing economy.

Then, there will be impact on corporate India and the banking system. Those companies which have raised dollar loans and do not earn dollars will have to pay more if they have not already hedged their foreign currency exposure. Around $20 billion worth of overseas loans are maturing in fiscal year 2014. For new foreign loans, the cost will go up. This will have a bearing on their repayment capacity and the banking sector’s non-performing assets—which many believed were approaching a plateau—may rise again.

The rupee has fallen 7.4% since January. Since 21 May, a day before US Federal Reserve chairman Ben Bernanke first hinted at slowing bond buying under the so-called quantitative easing programme, triggering a worldwide sell-off in bonds and equities, the rupee has lost 6.69%—the second biggest loser among the emerging market currencies, after Brazil’s real (7.21%).

For the record, from its January 2008 high of 39.27 a dollar, the rupee has lost close to 34%. But there is nothing unusual about it—when the economy is not in the pink of health, the currency cannot appreciate or even remain stable. Unless the macroeconomic fundamentals improve, RBI cannot do much to arrest the fall of the rupee, except for ironing out excess volatility.

Traditionally, rise in policy rates and liquidity tightening are the first line of defence against currency depreciation. It is highly unlikely that RBI will take that path when there is clamour for rate cuts in a slowing economy. In April, factory output growth was 2.3% year-on-year, weaker than what the markets had expected, and it is almost certain that economic growth in the first quarter of fiscal year 2014 that ended on Sunday would be lower than what the Central Statistical Organisation has estimated—5.7%.

Since January, RBI has cut its policy rate thrice, by 25 basis points (bps) each, to 7.25%. One bps is a hundredth of a percentage point. A rate hike is ruled out. It also should not hike the banks’ cash reserve ratio (CRR), or the portion of deposits that commercial banks keep with RBI.

As a temporary measure, the RBI can possibly ration its support to the banking system through its repo window but even that will be suicidal. Banks borrow money from RBI daily at 7.25% to tide over their temporary asset-liability mismatches. Any tightening will play havoc in the system when the economy is yet to get back on its growth momentum. Incidentally, the money market rates have already risen. The banks have hardly passed on the rate cut benefit to borrowers and the yield on the benchmark 10-year bond has risen by about 45 bps and corporate bonds by 70 bps in the past few weeks. The possibility of a rate cut by RBI in its July quarterly policy review is virtually ruled out. With the fall in the rupee, the overnight index swap rate has been rising—a clear indication of what the market expects from RBI.

One of the key reasons behind the sudden fall in the rupee is the sale of bonds by foreign institutional investors (FIIs). In June, they sold at least $5 billion worth of bonds. This is much higher than in some of the other emerging markets where the currency is depreciating. One reason could be that the Indian bond market has higher liquidity than many other markets and it is relatively easier to get out of India. That’s the price a liquid market always pays in such a situation. The good news is that bulk of the FII exposure in Indian bond market now is in short-term treasury bills and, unless desperate, they are unlikely to sell them.

Meanwhile, apart from selling dollars, RBI can always follow the other copybook measures such as withdrawal of the facility to cancel and rebook forward contracts by FIIs and banks and pare the net overnight open position limit of banks that sell foreign exchange to hit the speculators in the market. It can also open a window to support the oil importers, by taking away their dollar demand away from the market.

At $288 billion—down from $320.4 billion in October 2011—India’s foreign exchange reserves are now roughly 15% of GDP and among the lowest in the region, but RBI can still use part of the reserves to defend the currency. In 1997, it had tightened monetary policy to combat the ripple effect of the Asian currency crisis but at that time the foreign exchange reserves were roughly one-tenth of today’s pile. In 2011 and 2012, it had sold around $37 billion in rupee’s defence. It can do so even now. It does not need to sell too much if it knows how to hit the speculators through smart interventions.

The erosion in foreign exchange reserves because of dollar sales can be replenished by raising money overseas once stability returns to the currency market. It can also raise interest rate on NRI deposits to attract flow of money.

India had raised proxy sovereign bonds thrice—India Development Bond in 1991 ($2.5 billion), Resurgent India Bonds in 1998 ($4.8 billion), and India Millennium Deposits in 2000 ($5.5 billion). One more proxy sovereign bond should already have been raised when the going was good.

Tamal Bandyopadhyay keeps a close eye on everything banking from his perch as Mint’s deputy managing editor in Mumbai. He is also the author of A Bank for the Buck, a book on HDFC Bank. Email your comments to bankerstrust@livemint.com