Rupee @75-plus: Turbulence ahead
In this period of global turbulence, and with elections on the horizon, India must batten down the hatches and adopt credible and strong measures — along with clear communication — to stabilise the economy
With the US Federal Reserve raising rates, and the oil prices rising above $80 barrel after the recent OPEC meeting, there will be further pressure on the Rupee. That the rupee overshot by reaching ~72-73 to the USD, as some have argued, is wishful thinking.
The rupee had been stuck at around ~64-65 to the USD for almost three-plus years after recovering from a drop to ~70 during the taper tantrum in August 2013. But with Indian inflation well above that of its major trading partners RBI’s real effective exchange rate (REER 2005=100) index shows that the rupee was over-valued by at least 20 per cent in the beginning of 2018. Since then at ~72-73 to the USD it has lost almost 10 per cent of its real value, but has scope to depreciate further beyond ~75.
Between 2014 and 2017, India benefited from low oil prices, a windfall which helped lower the external deficit. High real interest rates and a stable rupee attracted unusually high short term capital inflows. India is now seeing these short term flows reverse sharply as the Fed raises rates and oil prices rise above $80 a barrel pushing the current account deficit (CAD) towards 3 per cent of GDP. The recent measures taken after the PM’s meeting with the finance ministry and the RBI were aimed at trying to slow down and perhaps even reverse the capital outflow by attracting $810 billion in inflows. But they are unlikely, on their own, to have much impact if concerns remain on the rupee.
The underlying structural problems that have made India’s external picture vulnerable must no doubt be addressed. Boost exports, reduce imports, make India more competitive and improve the economy’s energy efficiency. But these are all issues that will take time.
Between now and the next election India appears highly vulnerable to huge macro-economic disruptions. With a de facto (not de jure) open capital account, the trilemma dictates that India cannot have an independent monetary policy and a target exchange rate. If it wants to slow down the fall of the rupee further, it must raise interest rates or find other ways to attract capital.
Higher fuel prices and a weaker rupee will already re-ignite inflation in the coming quarter. If the rupee depreciates further and oil prices now rise above $80 a barrel petrol prices which have already risen above ~90 a litre in some parts of the country could exceed ~100 a litre unless state governments reduce VAT and the central government gives up some of its excise. But in doing so — the fiscal picture will surely deteriorate, raising bond yields and making India less attractive further accelerating capital outflows.
The FM has promised to maintain the fiscal target — while not cutting capital expenditure — which would require cutting recurrent expenditure sharply — not easy in an election year. Fiscal rectitude sends the right signal to markets. But allowing petrol prices to rise unabated could be very costly politically at both the state level and at the national level and may eventually get impossible to maintain.
In hindsight, the RBI should have increased reserves even further — perhaps to $500 billion when inflows were huge rather than allowing the rupee to strengthen. Reserves were increased from $250 billion in 2014 to roughly $430 billion in March 2018 but have since declined by $30 billion.
Surprisingly, even at $400 billion India’s FX reserves are being seen as insufficient to finance the CAD and debt payments and capital account outflows. In any case, unless market sentiment for the rupee changes just selling reserves in the market will not halt its decline. Building greater reserves would also have reduced the rupee appreciation during that period and helped India’s sluggish exports. The iron clad defense that was promised by the RBI now looks insufficient.
People say India is not as vulnerable now as when it was hit by the taper tantrum — when the CAD was 5 per cent of GDP. That maybe so but global risks are increasing and trade wars are looming if not here already. Global coordination has withered away and the G-20 which had promised so much after the 2008 financial crisis is no longer as effective. OPEC is unwilling to oblige by tempering oil price increases. Reserve back up facilities with other friendly countries to manage exchange volatility which may have been possible earlier will be a non-starter now.
There are no easy options. With the Fed likely to raise rates by at least 50 basis points in 2018, India will need to raise its RBI repo rate by at least 100 basis points to rein in the fall in the rupee — 50 bp now and at least 50 bp later. This will surely slow down the economy and create more problems for a weakened financial sector. The other option will be to resurrect the FCNR deposit scheme that was used by the RBI during the taper tantrum to attract NRI funds to stabilise the rupee. In hindsight this turned out to be overly expensive, but if it works may be a much cheaper option than having to raise RBI repo rates by 100-plus basis points to stabilise the rupee.
In this period of global turbulence, with elections on the horizon, India must batten down the hatches and adopt credible and strong measures — along with clearer communication — to stabilise the economy.