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Is the worst really over for the rupee? - Livemint
Updated: Sun, Oct 13 2013. 07 42 PM IST
The Indian rupee has rallied over the past few weeks, following a series of fortuitous global developments as well as some domestic policy innovations. The currency had touched a record low of 68.85 per dollar on 28 August.
The initial cues came from the US Federal Reserve. The rupee began its overdue fall after Fed chairman Ben Bernanke first hinted at the end of May that he would soon begin to reduce the monthly purchases of bonds that the US central bank has been funding with new money; all he had signalled was a slower pace of monetary expansion rather than an actual tightening of policy. Yet, the announcement was met with panic in global financial markets that are now addicted to easy liquidity. Emerging markets assets suffered in particular.
Bernanke later served up another surprise when he postponed his plan to taper the quantitative easing programme. The choice of the dovish Janet Yellen over the more hawkish Larry Summers as the next official candidate to head the Fed also helped stabilize markets.
Meanwhile, the Reserve Bank of India (RBI) took several decisions to defend the rupee. It took dollar purchases by oil companies off the market. An attractive swap deal for dollar deposits was introduced to encourage banks to bring in hard currency, and the latest numbers suggest that around $6.5 billion has already come in through this scheme, though with an implicit subsidy that cannot be maintained indefinitely.
What has happened in recent weeks only provides breathing space for Indian policymakers. The rupee will continue to be weak as long as India has a high level of inflation. The massive current account deficit means that the Indian economy is particularly vulnerable to any sudden reversal in global capital flows. So the recent strength of the rupee will not last unless the underlying economic fault lineshigh inflation and a high current account deficitare addressed. Ever more risky moves to attract short-term capital inflows are not a sustainable strategy.
The recent trade data offers some reason for cautious optimism. Finance minister P. Chidambaram has often said that he will try to keep the current account deficit below $70 billion in the ongoing fiscal year, or around $15 billion lower than what it was in the 12 months to March 2013. The latest data shows that the trade deficit in the first six months of the current fiscal year is around $10 billion lower than last year: $81.42 billion compared to $91.04 billion. It is always difficult to judge what the fair value of a currency is, but casual empiricism suggests that the improvement in trade numbers shows that the currency depreciation has worked. The trade deficit is only part of the current account deficit, but it would seem that Chidambaram may be able to succeed.
The other big problem is high domestic inflation. The sharp fall in the external value of the Indian currency mirrors its loss of purchasing power at home in recent years. The inflation record in recent months has been mixed. Core inflation measured by the wholesale price index has fallen steeply because India has been running a negative output gap for several quarters now. Core inflation in terms of the consumer price index (CPI) has been more stubborn, which is why many still expect RBI to increase the repo rate by another 25 basis points later this month, since it seems governor Raghuram Rajan is paying far more attention to this measure of inflation than his predecessors did.
So while focused policy actions have helped take some pressure off the rupee, India needs to have far lower inflation and a smaller current account deficit to protect its currency against global volatility. It is worth remembering that the strength of the rupee in the early years of the current century was at a time when inflation was low and the current account was in surplus. But that was also a time of very sluggish growth, so it is worth asking whether it will eventually be the business cycle rather than explicit policy action that will stabilize the rupee.
The past few weeks have been relatively benign ones, but they could merely be the calm before the next storm. This calm has to be used by Indian policymakers to bring down inflation as well as help cut the current account deficit. This also means that stimulus to domestic demand at this juncture will be a very risky strategy.
Updated: Sun, Oct 13 2013. 07 42 PM IST
The Indian rupee has rallied over the past few weeks, following a series of fortuitous global developments as well as some domestic policy innovations. The currency had touched a record low of 68.85 per dollar on 28 August.
The initial cues came from the US Federal Reserve. The rupee began its overdue fall after Fed chairman Ben Bernanke first hinted at the end of May that he would soon begin to reduce the monthly purchases of bonds that the US central bank has been funding with new money; all he had signalled was a slower pace of monetary expansion rather than an actual tightening of policy. Yet, the announcement was met with panic in global financial markets that are now addicted to easy liquidity. Emerging markets assets suffered in particular.
Bernanke later served up another surprise when he postponed his plan to taper the quantitative easing programme. The choice of the dovish Janet Yellen over the more hawkish Larry Summers as the next official candidate to head the Fed also helped stabilize markets.
Meanwhile, the Reserve Bank of India (RBI) took several decisions to defend the rupee. It took dollar purchases by oil companies off the market. An attractive swap deal for dollar deposits was introduced to encourage banks to bring in hard currency, and the latest numbers suggest that around $6.5 billion has already come in through this scheme, though with an implicit subsidy that cannot be maintained indefinitely.
What has happened in recent weeks only provides breathing space for Indian policymakers. The rupee will continue to be weak as long as India has a high level of inflation. The massive current account deficit means that the Indian economy is particularly vulnerable to any sudden reversal in global capital flows. So the recent strength of the rupee will not last unless the underlying economic fault lineshigh inflation and a high current account deficitare addressed. Ever more risky moves to attract short-term capital inflows are not a sustainable strategy.
The recent trade data offers some reason for cautious optimism. Finance minister P. Chidambaram has often said that he will try to keep the current account deficit below $70 billion in the ongoing fiscal year, or around $15 billion lower than what it was in the 12 months to March 2013. The latest data shows that the trade deficit in the first six months of the current fiscal year is around $10 billion lower than last year: $81.42 billion compared to $91.04 billion. It is always difficult to judge what the fair value of a currency is, but casual empiricism suggests that the improvement in trade numbers shows that the currency depreciation has worked. The trade deficit is only part of the current account deficit, but it would seem that Chidambaram may be able to succeed.
The other big problem is high domestic inflation. The sharp fall in the external value of the Indian currency mirrors its loss of purchasing power at home in recent years. The inflation record in recent months has been mixed. Core inflation measured by the wholesale price index has fallen steeply because India has been running a negative output gap for several quarters now. Core inflation in terms of the consumer price index (CPI) has been more stubborn, which is why many still expect RBI to increase the repo rate by another 25 basis points later this month, since it seems governor Raghuram Rajan is paying far more attention to this measure of inflation than his predecessors did.
So while focused policy actions have helped take some pressure off the rupee, India needs to have far lower inflation and a smaller current account deficit to protect its currency against global volatility. It is worth remembering that the strength of the rupee in the early years of the current century was at a time when inflation was low and the current account was in surplus. But that was also a time of very sluggish growth, so it is worth asking whether it will eventually be the business cycle rather than explicit policy action that will stabilize the rupee.
The past few weeks have been relatively benign ones, but they could merely be the calm before the next storm. This calm has to be used by Indian policymakers to bring down inflation as well as help cut the current account deficit. This also means that stimulus to domestic demand at this juncture will be a very risky strategy.
