The Indian Rupee: Depreciated Crunch

Many of my best friends are Indians. D. N. Gupta was one I met during my 1974 foundational training in National Academy of Administration in Mussoourie (India). We were very goods friends. I asked him once, "DN you are a smart guy. Why do think the others are stupid?" "B****** (unprintable Punjabi word), you at least admit I am smart. Who says I think others are stupid? " was his reply.  "You liar, B******" I said. He just gave a crooked smile. DN died later in a motor bike accident. I remember fondly time I spent with him!

The Indian economy was on upward growth track till 2008. India was considered next to China and a global power to reckon with. The reforms were on track and foreign capitals were moving into the country. Then the foreigners started pulling back seeing increasing political dysfunction: lack of commitment and action for progressive reforms and alleged corruption. The rupee began downward slide, investment slowed and deficit increased.   The shock came to the investors when Indian finance minister released a budget in March last year that proposed new taxes on foreign entities in India. Now India’s current account deficit (CAD)  for 2013 of $98 billion (4.9% of GDP), behind only the US at $473 billion and the UK 106 billion, is the key area of concern in its economy.

The CAD is created when the country's import bill is bigger than its earnings from exports. A widening CAD puts strain on the nation's foreign exchange reserves (FX reserve).   It also indicates that the country’s budget is under pressure having to borrow more money. India’s FX reserve as of August 16, 2013 stands at $278.8 billion . India wants to contain its CAD  at $70 billion (3.7% of GDP) in FY2013-14.

With Indian Rupee heading to 70 to a dollar, the situation may look good for Indian exports and tough for imports, such as oil which India imports 80% of its requirement.  The fact is even the export is dependent on import of a lot of raw material (e.g., from China). So the rupee devaluation will have a torrent effect, spiraling inflation if money is not kept tight to check the inflation. Then commodities of daily use will be more expensive. Therefore it is important not only to check the rupee’s downward slide but also achieve sustained recovery.

The global oil contracts are mostly settled in US dollars. So the Indian oil firms sell rupees to buy US dollars to pay for the oil imports. The transaction looked to stem the decline of the Indian rupee. Therefore  the Reserve Bank of India (RBI), among others, said it will sell US dollars to three state-run oil firms to help meet the daily dollar requirements of the firms estimated at about  $300m worth of daily oil import, needing about $8.5 billion every month.  The RBI’s  decision  to take the bulk of oil firms’ dollar demand away from the foreign-exchange market may do good near-term but the main issue will still be addressing domestic structural factors for sustained reversal of the trend. And then unfortunately the RBI move comes in the midst of volatility in the global oil price triggered by concerns of a military strike against Syria.

The offshore market for rupee trading has been increasing in size in the past year or so accounting for more than half of all rupee trading volumes. The trend has been outflow. Take money out now, convert it into a hard currency, wait for the rupee to fall to 70 or more against the dollar, then bring it back into the country and convert it back to rupees. The reason for speculators and investors to trade outside of India’s borders, many say, is because they are afraid that India might freeze funds inside the country.

Another indicator is the offshore-finance system. It is well known that Mauritius is the main conduit for foreign investment into India with 30-40% of the stock of foreign capital sitting in funds domiciled in the island. While some say  it allows investors to avoid red tape and unfair capital-gains levies, others argue that Mauritius is a conduit through which Indians send and bring back black money. The real truth may be somewhere in the middle.  With currency and the equity markets now getting cheap, the foreign capital will find value in them. The value alone is not a catalyst for purchase. The Government will need to show that they have no intention of tightening capital controls on foreign investors by reforming policies and regulations if needed. The Indian Prime Minister assured the Parliament on August 30, 2013 that there will be no capital controls or reversal of the reform  process. 

The RBI allowing currency to depreciate instead of trying to protect at particular level may be a sound strategy in one way.  If the currency depreciates, the import bill will go down, the export bill will go up  with only  letting the market forces do the work. While allowing markets to act, the government will need to work hard on appropriate reforms,  the key aspect to reversal of the trend.  "The current situation presents a challenge, obviously, to the government of India, but also an opportunity for the government to continue in its policy efforts on a variety of fronts," IMF spokesman Gerry Rice said.

Being so closely tied with the fate of Indian economy, we should be aware of the strategic reforms and moves the Indian government makes, and harmonize our economic policies and reforms not to let ripples turning into our economic tsunamis.  We obviously do not have capacity to take advantage of resulting Indian currency and equity market appreciation later. If we could, I feel, there is an opportunity.  Also, the government has to be eschewed borrowing in Indian currency, precisely because linkages of its solvency to volatile currency markets. Above all, we should remember that when big boys play defensive economic game, it’s in no way a zero sum game!