Indian rupee: Vulnerable as ever

Nov 11 2013, 20:04 IST
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SummaryIndian rupee: Policy focus has to shift from funding the CAD to reducing it on a permanent basis

The journey of Indian rupee (INR) against the US dollar (USD) can be traced back to the pre-Independence days when INR was at par with USD. After Independence, India chose a fixed rate currency regime with the currency pegged against GBP. However, with the passage of time and change in circumstances the pegs were modified.

In 66 years of Independence INR has depreciated 66 times against the USD (till end-August 2013). In the past five years, the rupee has depreciated by a huge 60%.

The vulnerability is especially evident with the onset of the new century. In 2003-2007, INR appreciated about 20% from 50/USD to 40. The caveat was that USD depreciated about 40% against the Euro, 35% against the Swiss franc and 25% against GBP. So against a basket of top three currencies, INR did not appreciate at all or rather depreciated. When the financial crisis hit the global economy INR depreciated 25% in 2008 alone to touch 50/USD. Again after a three-year consolidation, INR shot up to 68/USD (30% depreciation) in May-August 2013 as the talks of Fed taper gained ground.

This vulnerability owes it to various factors, some primary reasons being:

*Lack of infrastructure: The lack of infrastructure (port turnaround time, truck speed, labour costs) the country faces adds to the supply side inflation (rise in electricity cost is higher than WPI, labour costs are more linked to CPI than WPI, a reason for labor strikes) that reduces the competitiveness of the export sector and hence a constant depreciation in the currency is required to offset that productivity loss.

For example, INR has depreciated against the Chinese yuan by almost 70% since the start of the century and hence an advantage for exporters, but when we deflate the number by the inflation differential between the two nations {compounded inflation differential of around 67%--4% annual inflation differential) the advantage fades away even after accounting for the recent depreciation. Further, the comparison of the two nations in terms of policies and infrastructure reveals why India's trade deficit as a % of GDP rose from around 2% in 1990s to 10% in 2013, leading to a widening CAD (4.80% of GDP in FY13) and external sector crisis.

*Dollarisation of economy: The external sector i.e. import & export, was at 15% of GDP in 1990s when the economy was rather closed. With the opening up of economy and globalisation, the external sector has expanded to around 40% of GDP in FY13. This shows that there has been a rapid increase in the import content of the average consumption basket in the last 20 years. The rise in economic growth led to a greater rise in imports than in exports as the investments in the economy could not match the rising consumption rate, leading to a trade deficit reaching 10% of GDP in FY13. Further, the increase of the import content even in the export-oriented industries reduces the effectiveness of currency depreciation as a tool in correcting the external imbalance without an improvement in productivity.

*Oil: Oil is a politically sensitive commodity in India given the implication it has on inflation and the daily budgets of households. Hence the depreciation in currency strains the government fiscal balance since the burden is not passed onto end-consumers. Any rise in fiscal deficit without an increase in the productive capacity of the economy indirectly fuels inflation and reduces the effectiveness of monetary policy in maintaining the growth–inflation balance, primarily by the use of interest rates.

*Gold: As much as it is a tradition to buy gold in India, the investment in gold is a savvy economic decision by the Indian households as it is the only asset that strengthens the household balance-sheet in case of a depreciating currency and an inflationary environment. This, however, puts pressure on the financial savings in the economy and hold up investments (savings-investment-current account theory) as Investment is the sum of domestic savings and external savings (current account balance). The lack of investment to fund the infrastructure aggravates this inflation/inefficiency, leading to currency depreciation. Thus, the vicious cycle continues.

*Twin deficits: The deficits should be run only if they can pay for themselves in the future, else they reach unsustainable levels and stalls the development process and exert downward pressure on growth and upward pressure on inflation, creating a stagflationary scenario. The increase in fiscal deficit leads to higher government borrowings that crowds out the private sector, and hence investments in the economy, weakening growth and further fuelling deficit, and the vicious cycle continues.

Self-delusion is the first step towards disaster–we need to shift the medium- to long-term focus away from funding the CAD to reducing the CAD on a permanent basis, else we will continue to have large currency depreciation at regular intervals that can deteriorate the overall well-being of every citizen in the economy.

A stable currency regime required for a stable growth economy cannot be achieved unless the structural issues are addressed to improve productivity and keep a stable inflation environment, resulting in a more stable fiscal deficit and external sector which puts India on a sustainable growth path with stable FD, CAD, inflation and growth.

Piyush Garg

The author is executive vice-president, ICICI Securities

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