The rupee story continues to unfold much as anticipated but the unprecedented depths being plumbed (and perhaps the speed) are causing considerable alarm. Fortunately, despite the sharpest drop in the rupee’s value in the last two decades, it is fair to say that the authorities, while increasingly anxious, have not panicked yet. However, poor communication, seeming disarray within government and apparent reversals in monetary policy direction do not inspire confidence that is necessary to calm the markets.
The Reserve Bank of India (RBI) has engaged in some efforts to smoothen out excess volatility (see box at the end) with limited efficacy (see chart below on day-by-day movement), but it has not mounted a vigorous defence of the rupee that would almost certainly be futile. Indeed it would likely be ruinous especially in light of the quantum and quality of India’s reserves. Estimates of the firepower required must also factor in the volume of rupee (forward) trade occurring offshore.
Symptom, not a Cause: This is not to dispute that India may be heading into a crisis but rather that the depreciation of the rupee is a symptom, not a cause, of the economy’s malaise. In most simple and proximate terms, the rupee is under pressure due to the burgeoning Current Account Deficit (CAD) that has been at an unsustainable level, as well as the relatively high rate of inflation relative to our trading partners especially the industrialized economies. As shown in Table 1 below, the CPI differential between India and US, for example, averaged almost 8% p.a. over the past 3 years iplying a cumulative decline in the rupee’s purchasing power of 26% relative to the US dollar.
Also a Corrective Mechanism: Going forward, the rupee’s depreciation represents a powerful (but admittedly not painless) mechanism for reducing the severity (depth and duration) of the downturn and for hastening economic recovery. In particular a competitive exchange rate is a necessary (though not sufficient) condition to address the large current account deficit (CAD) and bring it down to sustainable levels by stimulating exports and switching demand from imports to domestic products.
Need to Address the CAD: To date there is no coherent strategy evident to reduce the current account deficit. Instead the government has been fixated on financing the CAD by attracting capital flows that provided substantial buoyancy in the past against more rapid depreciation of the rupee. This strategy has not only reached its limit but, particularly with its agnosticism as regards the type of inflows, may have added to India’s economic vulnerabilities to external shocks; encouraging more borrowing seems misplaced. Indeed the external debt of Indian firms is worrying investors who are also concerned with dropping rates of return on their investments.
External Shocks: The preeminent external “shock” has been foreshadowed since the beginning of this year by the improving outlook in the advanced economies, the US in particular. It is a near certainty that the Quantitative Easing (QE) by the US Federal reserve will “taper” within months. That has compounded the difficulties in major emerging markets arising from the loss of economic momentum this year which are all confronting currency pressures (Table 2). India has arguably been the biggest beneficiary of global easy money in recent years among emerging markets; hence, its currency having the sharpest fall need not be a great surprise. The other shock that rattled markets in late August, especially in Asia, is a familiar perennial, namely escalating conflict in the Middle East (Syria in the present instance) that drives up energy prices. Volatility is also certain to rule in financial markets, (especially currency), beyond these discrete, identifiable factors because the global economy is witnessing a ”multi-speed” recovery, large amounts of mobile capital is chasing yields and policy activism is the order of the day for governments and central banks seeking to avoid economic relapse around the world.
Table 2: Emerging Market Currencies: Units per Dollar
Challenging Times Need Wise Policies: Notwithstanding the critical role of exchange rate adjustment outlined above, it would be naïve, even callous, to discount the difficulties a depreciating rupee poses in the near term, including the possibility of compounding the crisis in case broader economic policies are misguided. While the delicate balance that is required in monetary policy has garnered much of the attention, the magnitude of the exchange rate correction is such that corporate debt (and relatedly banking sector health) has become a serious issue. The higher cost of imports, especially energy (oil, gas and coal) and capital goods will pass through into rising inflation as well as increased fiscal burden (e.g. due to increase in subsidies) controlling which is already difficult. If the government cannot curb expenditure then managing the budget deficit will require raising revenue; given the limited room for manoeuvre on most fronts, industry must brace itself for unorthodox policy measures and press for a wise, not just clever, approach.
Needless to say, businesses must also be prepared to internally address financial management issues typical of turbulent times, such as currency hedging (including requisite accounting), and dealing with reduced return to foreign equity, higher inflation and associated wage pressures, as well as higher foreign costs (e.g. onsite) and those closely indexed to foreign currencies. The big positive of course, and clearly more than just a silver lining, from a steady decline in the rupee’s value is the tremendous boost to profitability in the IT/ITeS industry. What pressures for repricing and/or adjusting contract duration from clients are likely to result?
Box: Measures taken by RBI to Curb Excess Currency Volatility