The newly appointed RBI governor, Raghuram Rajan, will have his task cut out when he assumes the challenging role this week, as the Indian economy remains sluggish. Below-par growth, large twin deficits (current and fiscal), a fragile currency and sticky consumer prices have led to muted business confidence. Political uncertainty is another cause for concern, as fresh investments might remain in cold storage till the constituents of a newly elected Lok Sabha’s treasury benches become clear.
In addition, considerable uncertainties prevail about the external economic climate amid fears of earlier-than-expected QE exit by the US Federal Reserve. While the leading central banks’ loose monetary policy to prevent a major global collapse has been successful, a smooth exit from the stimulus could prove to be tricky.
Concerns over how the imminent QE exit by the US Fed will play out has precipitated a sharp fall in the Indian rupee, which is down ~14% since May 2013, making it one of the worst currencies in the emerging markets (EM) in the past few months. Among the key factors behind the Indian rupee’s battering has been the elevated CAD (4.8% of GDP) and high fiscal deficit (4.9% of GDP in FY13), leading to FII outflows to the tune of $10 billion in the June-July period.
In view of the sharp fall in the rupee over the last few weeks, the RBI’s monetary policy focus has shifted towards exchange rate stability. The central bank has unleashed a series of liquidity tightening measures aimed at curbing speculation and arresting the slide of the rupee. Although the rupee did recover modestly after the RBI steps, concerns over FII outflows and large twin deficits sent the local currency to a new record low of 61.80 on August 6. Going forward, external factors like the Federal Reserve’s monetary policy stance will be a key driver, as it will determine the direction of FII flows into emerging markets like India.
Expectations have also mounted over a possible overseas bond issue (sovereign or quasi-sovereign) by India to try and turn the tide in favour of the rupee. Given the dire situation, the RBI could also resort to further monetary tightening by way of a CRR hike or in the worst case scenario, a repo rate hike. If at all things come to such a pass, the financial markets (equity and debt) will come under more strain.
The rupee’s swift fall from