Lessons from the slide of the rupee

Our external sector was said to be resilient. We were cruising along when, quite suddenly, the tide turned. The slide in the value of the rupee, the rising current account deficit, a substantial net capital outflow, persistent rise in crude prices, the pressure of rising protectionism in world trade, the firming up of the US growth rate and appreciation of the US dollar against major currencies have brought us a host of troubles — all interlinked and collectively leading to storm-like conditions that have resulted in India’s external sector becoming more vulnerable and less resilient.

Now the government is seized of the issue. We already have a slew of measures, including non-monetary measures like restrictions on non-essential imports (like finished electronics, certain textiles, automobiles, high-end consumer products), removing of the 5 per cent withholding tax on masala bonds, removal of the foreign portfolio investor exposure limits in corporate bonds and a freer ECB regime. The measures taken together are expected to garner $8-10 billion.

But how effective will the measures be? Essentially, the measures are of two types: restriction on imports; and encouragement of debt inflows. Import restrictions are fine as tools for crisis management but they go against the spirit of reform. Further, measures like the relaxation on “masala” bonds and ECBs amount to a quick fix just to postpone the problem. We are inviting more debt, making it easier for the debt to flow in but this carries the potential of a vicious cycle of debt servicing, higher external borrowing and higher external debt. That the external sector has been under stress is evident from the latest balance of payments (BoP) data for the period April-June 2018. The burgeoning current account deficit ($15.8 billion or 2.4 per cent of GDP) could not be financed in a non–disruptive manner as the net capital inflows were not adequate.

Capital outflows

The net inflows stood at $5.3 billion but we had a substantial net capital outflow — to the tune of (-) $8.1 billion — in the case of portfolio investments. This resulted in a depletion of $11.3 billion of the foreign exchange reserves (on a BoP basis) as against an accretion of $11.4 billion in Q1 of 2017-18. The reversal is, therefore, dramatic.

In aggregate, the outflows from the outstanding forex reserves over end-March 2018 till date (September 7, 2018) were $25.26 billion, which included a net sale of $6.18 billion and $1.87 billion by the RBI in June and July, respectively, for which data are available.

These sales clearly could not contain the volatility in the fall of rupee, given the force and quantum of the dollar exodus. The depreciation of the rupee during the financial year so far is around 9 per cent when the rupee moved in the range of 64.92 and 72.75 against the US dollar.

Another important aspect is the movement in India’s external vulnerability indicators, which include the ratio of forex reserves to total debt, short-term debt (residual maturity) to forex reserves, the net international investment position, and forex reserves cover to imports.

To the extent the forex reserves had declined around $25 billion over end-March 2018, assuming that other items such as external debt, import bills, and short-term debt remained at end–March 2018 levels, there could be substantial deterioration in the external sector vulnerability indicators.

The three important contributing factors for the weak rupee are: a higher oil import bill, an increase of 53.55 per cent during April-August 2018, resulting in a higher trade deficit and higher CAD; substantial outflow in the foreign portfolio segment and strengthening of the US economy in terms of higher economic growth; and increase in the Federal fund rate, making investments in the US more attractive vis-a-vis India.

Crude shock

While the external sector outlook could be guided by the global crude oil prices and hike in interest rates in advanced economies, particularly the US, coupled with the impact of trade wars resulting from increasing protectionism, it is imperative for the Indian economy to look beyond.

This means strengthening the non-oil exports. Over the years, India’s exports relative to GDP has been persistently declining. Also, income elasticity of demand for India’s export has remained stagnant and, therefore, the share of India’s export remained constant at 1.7 per cent in the world export.

In addition, as reported by the RBI in its Annual Report 2017-18, there has been “protracted stagnation in competitiveness.” Another important factor is the movement in the Real Effective Exchange Rate (REER).

At a conceptual level, increase in the REER index reflects diminishing competitiveness. Going by the trends in the movement of REER, which is showing persistently a rise in the Index, it is recognised that the rupee has been overvalued and is “associated with diminishing external competitiveness”.

However, as the RBI annual report has observed, the rise in REER in India is lower than in many economies, which include China, the Philippines, the UAE, Singapore, Thailand and Saudi Arabia. However, these economies are not seeing such a crash in their currency value as India because they do not suffer from a high CAD.

Thus, the recent measures announced by the authorities may provide some short-term relief but the sustainable solution to the problem is encouraging greenfield FDI and non-oil exports such as iron and steel, non-ferrous metal, and automobiles. Efforts should also be made to further strengthen exports of marine products and chemicals. What is important in this regard is to enhance quality-control measures.

The trend of the direction of exports is required to be shifted towards the Middle East and North Africa, apart from the US, China and the EU.

This is the long haul, and this requires clear policies and prioritisation at our end. Unfortunately, the issue is handled only when we see a fall and a crisis is presented. Good work is to be done even when the rupee holds strong, which it was a few years ago. That is the lost opportunity.

The writer, a former central banker, is a faculty member at SPJIMR. (Through The Billion Press)

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