CAD, rupee to remain stressed till ’19 polls

Any criticism (even minor) of the government’s economic management elicits a stock response: we have the fastest-growing economy, strong macro fundamentals and are in a sweet spot. This has not been trotted out these past two weeks as the rupee has depreciated.

The government announced its plan of action on September 14. In essence, it said: reduce hedging risk, borrow short-term, ease foreign portfolio investment (FPI), and the government would restrict “nonessential” imports. The next day, the government announced that it would adhere to the fiscal deficit (FD) target and there would be no cutback in capital expenditure.

The announcements did not turn the tide. Here’s why.

With a subdued investment climate, there are few corporate takers willing to take the exchange rate risk today. In any case, even shortterm loans take time. Foreign portfolio investment (FPI — mostly in debt) is driven by yield differentials and exchange rate expectations. These investments can (and do) become one-way bets. A large FPI inflow results in an appreciation of the domestic currency; that enhances the return on FPI. Equally, when things turn sour, there is a stampede to exit; yield differentials are wiped out by exchange rate depreciation. Nothing the government did (or announced) changed the investors’ perception on macroeconomic fundamentals or expectations. Forward markets for the rupee showed further depreciation. That counted for more.

The statement on government finances did not constitute a credible commitment. Revenue targets still look shaky. First, GST revenues are anything but buoyant and shrouded in uncertainty. Second, non-tax revenue (NTR) targets appear elusive. Disinvestment targets seem unattainable; and, appear risky in volatile stock market conditions. History does not provide solace. NTR targets have never been realised in the past 10 years except when there was a spectrum sale. Not much cheer on the expenditure side either. Subsidies are surely going to go up e.g. LPG and fertilisers. The MSP hike and a bumper crop imply a rising food subsidy bill. The bill on Ayushman Bharat is open-ended. Finally, there are limits on the pass through of higher crude prices. This is why markets and rating agencies have not bought the story.

Curbs on imports have not been announced. When they are, they will surely not boost investor confidence.

In the end, all that happened was the rupee recovering some value on the back of RBI’s intervention — selling FX reserves to buoy the currency. But the current account deficit (CAD) and the FD remain strained. Bond yields remain elevated.

We have come to this pass for two reasons: missed opportunities in fiscal management and turning a blind eye to exports.

For three years, the government received a huge windfall in the form of crude prices falling by 60 per cent. The government mopped up large tax revenues on oil. True, this fiscal room was used to reduce the FD. But doubts surround the quality of the fiscal adjustment. Given the huge political capital available, much more ought to have been done to reduce subsidies and redirect expenditure. Subsidy reductions were imperceptible; and the food subsidy increased. In the past two years, there were large capital expenditure cuts to meet the FD target. The looming NPA crisis simply did not get the attention it deserved. All this while expenditure on “new” schemes (with smart acronyms) ballooned. Today, expectations on the future FD are based on these considerations: the resources required to meet burgeoning subsidies, the recap requirements of banks and the political compulsions of an election year.

The sharp reduction in the CAD because of the oil price surprise created a false sense of security. Exports flatlined without eliciting a policy or strategic response. The comfort of a small CAD led to complacency on the export front. Even as the real effective exchange rate appreciated, there was no response. The “strong rupee — strong economy” thesis permeated government thinking with disastrous consequences. Then came the GST disaster that locked up exporters’ capital in taxes paid. Despite all warnings that this would happen, the government went ahead; and, refunds to exporters have been held up for years. The few proposals to promote an export thrust posed to the Ministry of Finance were turned down — for want of resources! While the government was patting itself on the back for improving the Ease of Doing Business, the CAD went out of control.

More than two years ago this author mooted specific proposals in this newspaper: to reduce subsidies, redirect expenditure and revive exports (September 21, 2015, November 2, 2015, November 3, 2015, May 28, 2016) — to no avail.

What lies ahead? An interest rake is inevitable and bond yields will not recede. This will impact slowly reviving capital formation. The CAD and the rupee will remain under pressure up till the 2019 elections. Oil prices are firm and may rise. Forward markets expect further depreciation in the first half of 2019. That means pinning all hopes on the consumption component of aggregate demand. Other signs are not good. The construction industry is in trouble. The sugar economy is a total mess. Unresolved problems in the power sector are well known. And, coal is back in the news for the wrong reasons. Turbulence in financial markets is compounding these woes.

We are not in a sweet spot. Time to wake up?