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The recent depreciation of the rupee has been creating news, with views pouring in from every quarter. The persistent current account deficit (CAD) has been blamed for this sorry state of affairs, and the role of the RBI in this mess is being debated.
Is the rupee depreciation on account of policy missteps? Whose door should we lay the blame on? The RBI, the government, or you and me, with our limitless penchant for buying gold. Is there ‘a’ single equilibrium exchange rate for India that RBI policy can lead us to?
The answer lies in understanding what accounts for the exchange rate movement. The exchange rate within a market-determined system is determined by the market forces of demand and supply of foreign exchange.
As such, there is no single equilibrium exchange rate, other than that determined by the market. The latter is affected by both movements on the current and the capital account. Due to the lack of latest data, we can only make an educated guess on the reasons for the sharp depreciation in the rupee.
BEHIND THE DEPRECIATION
Turning to the current account, it appears the growth in exports was unable to keep pace with imports, leading to a supply constraint in foreign exchange. The reduction in export growth has more to do with weak external demand, coupled with low export competitiveness.
On the demand side, within imports, the downside risk of oil imports on our trade deficit continues, and it is aggravated by the high propensity to consume gold.
It appears that the cushioning effect of software exports and workers’ remittances, which had helped bridge the merchandise trade gap in the past, may no longer be available. Additionally, the outflows on account of non-software services could have been higher due to rupee depreciation, worsening the supply constraint.
As regards capital flows, the latest SEBI data on the daily trends in FII investments reveals negative net FII investments almost all through June 2013. Such negative net investments pose further foreign exchange supply constraints.
A more worrisome trend has been the rise in various types of debt capital flows. Short-term debt on residual maturity rose to $166.1billion in Q3 2012, accounting for 44.1 per cent of total external debt, aggravating further the problem of supply of foreign exchange.
Furthermore, the expectation of a discontinuance of Quantitative Easing by the US has impacted the foreign exchange market of all Emerging Market Economies, with even current-account-surplus countries like Malaysia having suffered a depreciation.
Hence, the much-debated demand side factors, originating from high oil and gold imports, perhaps tell only a part of the story. More important and overlooked are the supply side factors ---weak export growth, decelerating software service exports and workers’ remittances, possible outflows of non-software services, declining trend in net FII flows and higher outflows on account of short-term debt.
POLICY OPTIONS
India’s accumulated foreign exchange reserves are mostly through high-cost debt flows, while India is a ‘net liability’ country.
Hence, the moot question is -- should forex reserves be used to meet the vagaries of market sentiments?
Should the authorities, as during the June 2012 bout of depreciation, go in for encouraging debt capital flows (NRI bonds, etc.), as has been widely reported?
The RBI’s avowed approach to exchange rate management has been volatility-centric.
While the constraints on the RBI are understandable, the RBI would have to resist the temptation of attempting quick-fix solutions. Rupee depreciation has to be understood from a long-term perspective and the structural constraints rectified. Relaxation of FDI sectoral caps will get in the much-needed capital inflows.
The present asymmetries in information which prevent the market from reaching a ‘natural’ equilibrium need to be minimised. The market needs contemporaneous data on the valuation component of the weekly forex reserves, so that it stops ‘guesstimating’ the extent of BOP deficit.
In hindsight, the RBI’s policy initiative during the previous year’s episode of depreciation – of providing incentives for higher debt flows --- was myopic. Such initiatives are self-defeating, as they result in debt servicing outflows in the medium term.
The clamour to do the same needs to ignored. Unless the underlying causes of the rupee depreciation are understood, there would be a tendency to take short-cuts to what essentially is a long-term issue.
(The authors are Professors at the SP Jain Institute of Management and Research, Mumbai.)
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