If the announcement-effect of any government policy were to be the immediate judge of the efficacy of the same, then the five-point currency revival plan announced on Friday did not quite deliver. RBI reference rate closed on Friday at Rs 71.81/USD; the Monday rate was Rs 72.55/USD. This is not surprising when the belief is that the rupee is being driven more by external factors that make the dollar stronger and other currencies weaker. Further, the measures announced are contingent on market players responding in a positive way, which, practically speaking, would take at least six months. In that case, do these steps make any sense?
The answer is yes, as the government had to do something to stem the falling rupee. RBI has been selling dollars in the market to the extent of $16 billion in the first four months. Forex reserves have come down by around $25 billion between March end and September 7. This means that RBI intervention through the sale of dollars has not quite worked out. It was left to the government to do its bit, and the five-point agenda, combined with the proposed measures in the field of trade, were appropriate.
The approach has been two-fold. The first is to tackle the capital account by getting more inflows while the second part, which will be revealed in the course of time, is to reduce the trade deficit. Both the steps are quite clinical as they address the issue to the extent that fundamentals are reversed. The impact of these measures can be analysed sequentially.
The first part relates to external commerical borrowings (ECBs), where the government has made two specific announcements. The first is to reduce the tenure of ECBs for amounts of $50 million to one year from three. Prima facie, this sounds good, though it cannot be a permanent measure. One of the reasons for RBI to have kept a limit of three years was to ensure that the borrowings were associated with projects that were of a long-term nature. By lowering the level to one year, there will be risk of the bunching together of repayments in the subsequent year that will cause problems.
The other point made here is that the mandatory hedging condition for infrastructure companies has been done away with. Again, while this sounds exciting, the question is ‘are we increasing the forex risk of our projects’? It may be pointed out that RBI has been exhorting companies, which borrow from the ECB market, to partly hedge their exposure as part of prudent forex risk management. By letting companies go ahead without the hedging clause, we could be making this entire category of loans a risky one. Therefore, both the relaxation measures pertaining to ECBs carry a downside risk that can get magnified along the way.
The second set of factors pertains to masala bonds. Here, too, there are two announcements. The first is the removal of the withholding tax, which is a positive for these bonds. The second is allowing banks to underwrite these issuances and also be a market maker. There is no problem with this rule. The important part, however, is whether or not these bonds will catch on. Masala bonds are rupee bonds raised in a foreign currency in overseas markets where investors could be Indian expats or investors looking for diversification. These bonds become attractive when rates in the country are lower and the masala bonds offer higher returns. The exchange risk is, however, borne by the investor. With interest rates increasing overseas and the rupee becoming volatile, this becomes less attractive. Hence, while the framework for raising such bonds has been liberalised and is positive, the response of players needs to be gauged. The history of such issuances has been restricted to a small set of companies, and even if this has to work, it would be over a longer period of time.
The third target has been FPIs, where their exposure to single company issuances, or shares in portfolios, has been liberalised. The response will be interesting because it was observed that when the FPI limits were raised earlier this year, the inflows had turned negative. Quite clearly, the factors which drive FPI investment are a basket of factors such as the state of growth in other countries, movement of interest rates, Fed action and so on. These higher limits may thus not be able to actually increase the flows significantly.
The other thoughts expressed by the government which will take shape pertain to trade. Curbing imports is a way out and can be done through higher duties as quotas are now passé. The non-essentials that can be targeted would be gold and electronics as oil cannot be touched given the fact that domestic prices have already gone up for refined products. Increasing taxes on such items has worked in the past and would be worth experimenting. While gold demand can be impacted, which in turn can affect exports of related industries like gems and jewellery, the demand for electronics would be mixed. Presently, mobile phones and laptops are snob articles where the price may not be a limiting factor. Therefore, higher duties and higher prices would probably mean higher inflation but unchanged demand. Therefore, in the present situation, where core inflation is rigid and in the upward direction, higher duties will only increase the inflation indices as a collateral effect.
Incentivising exports has also been spoken of. This is again something which works with lags. Export credit, access to infra and amenities, tax breaks and refunds are something that can be explored. However, these moves are more likely to improve profitability of EOUs though they may not lead to higher exports which have tended to depend more on demand conditions in the importing countries and where the price factor is only secondary.
The measures announced could be described as being the ‘final measures’ (there can still be a last one in the form of a NRI bond) taken by the government to control the fundamental factors affecting the currency. The sale of dollars by RBI can only be done intermittently and cannot be a permanent measure. Opening a separate window for oil companies can assuage demand in the market, but at the end of the day, it is a zero sum game. As reserves fall, the rupee will decline.
Besides, with the currency direction being driven more by what the US does, such measures may placate but not really succeed in completely reversing the direction of the movement of the rupee.
-The writer is Chief economist, CARE Ratings. Views are personal