Falling Rupee may help exports, but oil imports are set to surge while inflation and deficit could worsen
The rupee weakened to a record low of 74.72 against the dollar on October 10, 2018 and has been hovering around that rate ever since. Over the past few months, it has shown itself to be among Asia’s more volatile currencies. Despite this, RBI has maintained the staunch policy stance of not intervening to prop up the currency, and the rupee has been allowed to continue on its downward trend in a mostly unrestricted manner.
There are several good reasons why RBI has not intervened as yet. Among these is that the rupee is commonly held to be overvalued, due in part to the high volume of capital flows to India in response to accommodative monetary policy in advanced economies in the aftermath of the 2007-08 financial crisis. Commentators argue that allowing the rupee to depreciate sharply would return it to its fair value. Furthermore, although India’s growth rate has been near the highest among major economies, the country’s exports have not fared correspondingly well over the past few years. The depreciating rupee is therefore seen as a blessing in disguise for the export sector.
Returning a currency to its fair value as part of a policy package that would increase exports are worthy goals. However, increasing exports depends not only on the currency, but also on strong external demand. Of late, the latter is weakening due to economic uncertainty and financial turmoil in many countries as oil prices rise and protectionist policies by major economies take their toll. Furthermore, while there is strong economic rationale for allowing market forces to almost fully dictate the trajectory of the rupee, going forward, other economic spillovers could impact policy decisions. These include India’s high reliance on oil imports, inflation, the stressed financial sector, and the fiscal deficit.
India is among the top importers of oil in the world, and over a fourth of imports are oil imports. India also has the fastest-growing appetite for oil imports in the world. The Organization of the Petroleum Exporting Countries (OPEC) estimates that oil demand in India will grow at a rate of around 3.7% per year, making Indian demand for oil constitute a staggering 40% of overall global growth in oil demand over the next two decades. Already a heavily oil-dependent economy, India is projected to become the largest global consumer of oil imports by 2040.
The oil price collapse from over $110 per barrel in June 2014 to less than $35 per barrel in February 2016 eased India’s import bill. Oil prices plummeted then due to a confluence of factors including the largest volume increase in history of US oil production with the discovery of shale oil, OPEC members’ decision not to act as swing producers and curtail oil production, and weaker than expected demand from Europe and Asia, especially China. The sharp drop in oil prices benefited the Indian economy.
Oil prices have been rising, however, by 30% this year alone to over $85 a barrel in October 2018. Some predict that oil prices might reach the $100 a barrel mark by the end of the year. While exporters might benefit from the weaker rupee, the relatively costlier oil imports in domestic currency terms will adversely affect Indian oil importing companies as well as upstream supply chains. Public finances will also come under additional pressure. Excise duties on petrol and diesel have already been lowered by Rs 2.5 per litre, amounting to a revenue decline of Rs 21,000 over a full fiscal year. While the Centre is likely to absorb the immediate effects due to buoyant direct tax revenues, if the currency keeps weakening, thereby ratcheting up the oil bill, the government may be forced to consider increasing the fuel subsidy. This in turn could potentially affect the FRBM target of reducing public debt to less than 60% of GDP by FY23, which has different consequences on its own.
The double whammy of a freely falling rupee and rising oil prices will also affect WPI inflation, which reached a four-year high of 5.7% in June 2018. The general rise in price levels may force RBI to raise the policy rate more than planned for. This would raise the cost of borrowing, putting stress on infrastructure investment projects and indebted financial firms. The financial sector is already showing signs of fragility due to tight liquidity. The Sensex fell by 6.3% in September 2018, the biggest monthly drop in two and a half years. While RBI has recently relaxed short-term liquidity constraints by allowing increased bank lending to NBFCs, concerns about financial fragility, a rising fiscal deficit, and increasing oil prices may spook already shaken foreign investors further, causing additional capital flight and rupee depreciation.
In sum, a freely falling rupee has benefits including a potential boost to Indian exports. However, the current global climate does not hold all positive news. Global demand for Indian exports is likely to face headwinds over the next few years due to downside risks to global growth, while at the same time India’s increasing dependence on an increasingly costly oil import bill will place strain on fiscal resources. This, along with potential capital flight and emerging pockets of financial fragility, can put additional downward pressure on the currency, creating a vicious feedback loop. Going forward, therefore, it will be challenging for the government and RBI to achieve the Goldilocks “just right” balance between allowing market forces to determine the rupee rate and deciding to intervene.
- Tara Iyer is an Economic consultant at the Asian Development Bank in Delhi. Views are personal