Not just a shaky CAD

The major cause for the rupee’s devaluation has been the massive merchandise trade deficit due to the high level of merchandise imports (not just oil and gold) unmatched by exports.

The country has become dependent on capital inflows to finance the trade deficit. This is simply not sustainable. It is a weak position to be in, and a treadmill from which it is difficult to get off.

Simultaneously, there are several other major factors pulling down the value of the rupee.

Spike in external debt

The first of these has been getting media coverage in the recent past, and that relates to the increase in short-term external debt due for repayment in the next 12 months.

The country has to find the foreign exchange to meet this obligation.

The forex markets are seeing this increasing demand for dollars which, in the face of the mounting current account deficit, is depressing the value of the rupee.

Short-term debt, which was under 4 per cent of total external debt 10 years ago (Table 1), has ballooned to a quarter of total external debt as of December 2012.

The country’s short-term external debt has increased by a factor of 25over the past decade to $92 billion as of December 2012.

On October 6, it was reported that short-term debt (residual maturity of up to one year) was $170 billion as of June 2013, with its share in total external debt going up to 44 per cent.

This is the result of policy measures permitting loose external funding over the past decade, on the assumption that money will continue to flow in unabated.

The assumption is highly suspect, and hence we have the unfortunate situation of senior members of the government pleading with foreign investors to invest in the country, and calling for further “reforms” encouraging FDI/FII inflows.

The unseen outflow

Foreign exchange outflow due to investments into the country has gone up seven-fold over the past 10 years to over $22 billion last year from a mere $3.5 billion in 2002-03 (Table 2), clearly another factor causing the value of the rupee to go down.

There is no talk about this whatsoever. Of course it is natural for investors to get a return, and it is fair that they get it.

From a policy perspective, the dialogue is only about what comes in. When policymakers talk about FDI/FII inflows, they should simultaneously talk about the potential outflows for a balanced perspective.

As a result of the factors causing the huge and unprecedented drain in forex, India achieved the undesirable distinction of being the nation with the largest current account deficit of over $80 billion last year, barring the US, in a field of 193 countries listed in the CIA World Fact Book (Table 3).

The US, which is in the privileged position of being able to print the world’s reserve currency, does not count on this table. This is a distinction that India can do without, and there is no cognisance of this fact.

The Finance Minister recently stated that India’s current account deficit should be brought down to $70 billion for the year ending March 2014 (although how that is to be achieved is not spelt out).

Still on top

It should be noted that this will still keep India on top of this league table.

Reports at the time of writing say that the current account deficit has come in at $6.8 billion for the month of September, thanks largely to the restraint in imports of gold.

This is the lowest monthly deficit in the past two years, and it was reported as some sort of an achievement.

It would be prudent to be aware that this is very temporary since the underlying causes of the problem have not been addressed.

An external development — the proposed Quantitative Easing of the Federal Reserve in the US — was blamed by the authorities as the main cause for rupee devaluation in late August.

The explanation offered was that some portion of the foreign capital would have shifted back to the US and that put pressure on the rupee.

The question to ponder is this: Why and how did India get into such a helpless spot that the proposed action of the Federal Reserve can cause such havoc to the value of the rupee? After all, the Federal Reserve will do what it thinks is best for the US and it will never subordinate its national policy to serve the needs of other countries.

The Federal Reserve has held its proposal in abeyance for now but it is only a matter of time before it comes up again. Another external factor to consider is speculation against the rupee.

An external market for the rupee — the non-deliverable forward (NDF) market — operates offshore, outside India’s jurisdiction.

This market has been growing significantly over the past five years, with concentration in London and Singapore.

What started as a hedge against risk of fluctuation has reportedly crossed the thin line to speculation against the rupee. It is reported that the average daily trading in rupee NDFs in London alone increased from $1.5 billion in 2008 to $5.2 billion in 2012, a jump of 250 per cent.

The government has taken note of the impact that the offshore NDF market for the rupee has on the onshore market, and is talking of steps to control this phenomenon.

How did India allow itself to be in such an exposed position in the first place?

The authorities are not coming clean on the total problem. Blaming external developments, which were only the proverbial last drop that caused the cup to flow over, is merely a deflection.

India has to urgently do a lot more than what has been done till now to gain control of the value of the rupee. Anything less is a disaster waiting to strike.

(The concluding and Part 3 of this series that will appear tomorrow will look at practical steps to restore the value of the rupee .)

(The author is Group CEO, R. K. Swamy Hansa and Visiting Faculty, Northwestern University, US. Views are personal.)

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