Opinion Out of currency

Of course,the problem with bilateral currency rates is that they do not tell us the reason for rate changes. Specifically,is the decline primarily due to the general weakness of the rupee or due to the broad-based strength of the dollar?

While the rupee has declined sharply against the dollar,it has also depreciated significantly against the euro and the Singapore dollar,while declining somewhat against the Japanese yen too. This suggests a combination of the general weakness of the rupee,as well as the strength of the dollar. Other emerging market economies (EMEs) dependent on foreign capital flows have also experienced currency declines against the dollar,with the rupee,along with the South African rand and the Brazilian real,having been hit particularly hard.

On the one hand,the dollar’s strength seems to have been triggered by the Federal Reserve’s explicit signal on June 19 that the era of ultra-loose monetary policy in the form of quantitative easing (QE) is coming to an end,leading to the reversal of capital flows from India and other EMEs. Countries like India,which run a structural current account deficit (CAD) and are heavily dependent on foreign portfolio investment to finance the CAD,are especially vulnerable. On the other hand,the rupee’s slump was caused by a combination of two factors. One,a general mood of pessimism about India’s economic growth prospects and policy inaction to tackle supply-side bottlenecks; and two,the sustained and growing macroeconomic imbalances in the country,coupled with a lack of active intervention in foreign exchange (FX) markets by the RBI.

This suggests that if the Fed does not actually reverse its monetary policy course in the near term,or if there are signs of improvements in India’s fundamentals — at least as perceived by the markets — the rupee ought to recover against the dollar. Indeed,the rupee had stabilised,at least temporarily,mainly due to the FX interventions by the RBI,which has been concerned about the dramatic decline of the rupee,both in its own right,but presumably also because of fears of the exchange rate pass ing through into domestic inflation.

When the Fed puts a stop to its aggressive QE policies,it will presumably be because the US is expected to experience strong economic growth,which will actually be a good thing for India and other EMEs,in terms of their export and investment growth. It is not apparent that investors will be bearish on the rupee,or on other EME currencies,unless there are some negative country-specific reasons or global shocks.

So,apart from unforeseen negative shocks,what are the possible longer-term worries for the rupee? Contrary to credit rating agency Fitch’s optimism regarding India’s prospects,the country continues to flounder,growth remains anaemic at a 10-year low,data on capital expenditure remains weak,inflation remains high and persistently exceeds most trading partners’,and the CAD continues to be problematic,especially if driven by fiscal profligacy or an uptick in commodity prices.

Given that India’s high CAD is predominantly financed via portfolio flows,rather than FDI,the country is vulnerable to changes in global sentiments and other external shocks. Unfortunately for India and other EMEs,there is not much we can do if there is a rapid unwinding of positions once the Fed tapers off its current long-term asset purchase programme.

However,unlike EMEs such as Indonesia,India’s capital outflows are primarily of the portfolio equity variety. While controls on capital outflows during a period of stress are unlikely to be effective,there may be some scope to attract further portfolio debt inflows. The recent measures to increase government debt limits for FII investors is important in that regard,and more should also be done to give an impetus to FDI inflows. Along with this,keeping interest rates more or less unchanged,with the possibility of FX intervention by the RBI in the event of another round of disorderly currency and financial market pressures,may be the best option in the near term. To this end,the rebuilding of FX reserves since mid-2012 has been important.

What India really needs to focus on is the part of the structural rupee weakness that is largely home-grown — 30 per cent since 2008. Policymakers have been quick to put most of the blame on India’s gold imports. However,these imports have,in turn,been partly driven by perceptions of loss in the rupee’s purchasing power,both internally due to inflation,and externally due to depreciation. Better macroeconomic management,as opposed to further piecemeal regulations on gold imports,which have likely led to a front-loading of gold purchases,is what is needed to manage the gold import problem. Failing this,we will be talking about the rupee hitting yet another new “all-time low”.

The writer,professor of international economic policy,School of Public Policy,George Mason University,is currently visiting IIM,Bangalore

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