Column: Rescuing the Rupee

Written by Ajit Ranade | Updated: Aug 12 2013, 06:14am hrs
The fiscal imbalance is the root cause of the twin problems of inflation and the difficult balance of payments position. This is a statement made by the finance minister of India on the floor of Parliament. It was on March 19, 1990, and was part of the budget speech of Madhu Dandavate. The more things change the more they remain the same. In many respects, the economy might have regressed to a pre-1991 state, especially due to an eight-year persistent non-oil trade deficit, and an overvalued exchange rate. Dandavates statement is a reminder, if ever needed, that the external current account reflects the state of accounts of the government. The external strength of the rupee cannot be totally divergent with its internal strength. Since internally the rupee has lost at least 50% of its purchasing power in the past five years, it is but natural for it to move from 40 to 60 in parallel.

Hence trying to artificially suppress this pressure cooker of rupee depreciation is bound to fail. You need to let the steam off. But, of course, that does not mean you dont intervene to curb volatility.

Since currency markets get carried away the herd mentality causes traders to behave as if there is no bottom. Hence it is important to calm the markets periodically. However, if you ignore fundamental and structural factors and reforms for too long, then you get into a tight corner. This is our current predicament. The widening trade deficit caused by imports of coal, fertiliser, edible oil and capital equipment, was flagged three years ago, by the commerce ministry itself. This needed a structural response, which was outlined in the ministrys remarkable strategy paper. But inaction on structural dimensions combined with high fiscal deficits and inflation has led us to be cornered.

In this cornered situation, the Reserve Bank of Indias harsh measures came as a nasty shock, and caused disruption in the bond market. The rise in yields might entail a mark-to-market loss of R40,000 crore to bank treasuries. To curb volatility in currency, RBI has unwittingly caused huge volatility in yields. This outcome vindicated the RBI Governors own statement, where he had said that a failed intervention is worse than no intervention.

We are caught in a situation where every response now will have an unpleasant side-effect. In the lingo of economists, we are looking for second-best solutions, if not third-best. So, measures like tightening money markets, raising short-term interest rates, sucking out liquidity, asking exporters to bring back their money immediately, requiring minimum stay for FII investments (unremunerated reserve requirement), hiking import duty on gold and other non-essential imports are all basically measures which will cause some damage, especially to economic growth and sentiment.

Even the move to sell semi-sovereign dollar denominated bonds can extract a steep price. Attracting debt inflows require measures that deter equity inflows. There are too many trade-offs. Besides, all these are short-term measures, which will not eliminate the need to do structural reforms as articulated in the commerce ministry paper. India needs to get a sustainable path of a CAD of around 3% of GDP, and a small enough savings investment gap, not undermined by a large fiscal deficit. Self-sufficiency in coal, fertiliser, edible oils, pulses is imperative. The textile export opportunity may be re-opening thanks to rising labour costs in China and mishaps in Bangladesh. Even implementing the national manufacturing policy will have positive spinoffs for the current account.

As we pursue the structural agenda, here are four additional suggestions to stem the rupee slide.

Firstly to set up a large swap line with China. Secondly to issue short-term gold bonds which are exact gold substitutes. Thirdly to offer an amnesty scheme. And fourthly to exploit opportunities for expanding trade with Iran.

Half of Indias non-oil trade deficit is with one country alone, i.e. China. This can be plugged by commensurate annual capital flows from China into Indias infrastructure. It will amount to merely 1% of Chinas foreign exchange stock, and will meet their pressing need to diversify into non-dollar assets. India can reciprocate with an assured return in RMB terms. We should also open a currency swap line. This means that their exporters get paid locally in RMB, and the swap balances are settled once every month or two months. This reduces the pressure on the spot dollar market as well as reserves in India, even if temporarily. India has already opened swap line with Japan, and China has swap lines with half a dozen countries.

The second suggestion is of a gold bond is to ease the pressure due to import of physical gold. This bond with be a perfect substitute for physical gold. The holy grail is to demat gold completely, as was done in the US in the 1930s. That is unlikely to happen in India. Instead the government can start building peoples trust in a paper instrument, by first offering gold bonds with only a five-year maturity. Small easy successes can breed more confidence. This step is not as extreme as completely dollarising Indias economy (a la Argentina), but is instead a small de facto dollarisation. The KYC norms applicable to gold bonds must be considerably diluted in the initial years. Else theres little chance of success.

Which leads us to the third suggestion of an amnesty. This should be only for gold ornaments. One-time offer to surrender gold in exchange for paper, no questions asked. No wealth tax imposed. This is a one-way only demat of gold in an amnesty cloak. No reverse route is available, as in the five year gold bond option.

The final suggestion relates to Iran. There is only one country in the world which is geopolitically equidistant, and friendly to both US and Iran. That country is India. This position has not been sufficiently strategically exploited. India has been over-compliant with the US diktat, which far exceed UN sanctions. Iran has already agreed to accept rupee payments for all of Indias import of oil. This excess trade surplus of Iran can be deployed to buying Indias exports, which can in turn be promoted with a fiscal nudge with the focus market scheme. India is already building a port in Iran, but many projects lie unclaimed, as Indian companies do not even bid in global tenders. Agriculture, pharmaceuticals and engineering are sectors of promise.

A year after Dandavates speech, India unleashed epoch defining reforms in 1991. So, hopefully, the current woes and temporary fire-fighting measures are only a precursor to some big moves in the economy coming soon.

The author is chief economist with Aditya Birla Group. Views are personal