That sinking feeling again

Mythili Bhusnurmath

With the rupee hitting an all-time low of Rs 69.01 against the US dollar late last month, Niti Aayog Vice-Chairman Rajiv Kumar’s statement that ‘the rupee is overvalued in terms of its Real Effective Exchange Rate (REER), there is no reason to worry’ seems to be a case of wishful thinking rather than a dispassionate assessment of ground realities.   

The domestic currency is still overvalued relative to its REER, despite the sharp fall in the exchange rate vis-a-vis the dollar. But where Kumar errs, and errs hugely, is when he states there is no cause to worry. There is every reason to worry. A weakening domestic currency is both a response to heightened external sector vulnerabilities and, in turn, a trigger that could set off a vicious cycle of capital flight and further currency weakening that could imperil India’s hard-won-but-still-fragile macro-economic stability. 

The country’s Current Account Deficit (CAD) — at 1.9 per cent of GDP — is now the highest in the past five years. Global oil prices are rising and there is a looming prospect of trade protectionism, if not outright trade wars. In such a scenario, our dependence on imported oil (close to 80 per cent of our energy needs are met through imports) is bound to see the CAD — the difference between what a country owes to the rest of the world and what is due to it from the rest of the world — widen further. 

Higher exports could help narrow this deficit, especially since a weaker rupee should make our exports more competitive in global markets. Except that the rupee weakness comes at a time when the global demand is subdued, thanks to rising trade protectionism and the looming threat of even trade wars. Consequently, we cannot expect exports to help narrow the CAD.  

The flip side of a weaker rupee is that it makes imports more expensive. However, the primacy of oil in our import bill, thanks to our inability to reduce our dependence on imported oil, means there is not much we can do to reduce imports and thereby narrow the CAD. The focus, therefore, should be on financing it. 

Economic theory says as long as the rest of the world is willing to finance a country’s excess consumption, which is what CAD essentially represents, there is no problem. The problem only arises when, for whatever reason, overseas investors decide they do not wish to continue financing the deficit.  

This has proved true in the Indian context, where in the initial years of the Modi government, our CAD was comfortably financed by overseas portfolio flows. As long as overseas investors, enthused by the India growth story and eager for a share in the pie, were willing to bring in dollars, there was no dearth of dollars to finance the CAD. Indeed, our problem was one of plenty! As a result, not only did the rupee appreciate beyond what was warranted by our fundamentals, the RBI had to step in and buy dollars (thereby adding to its forex reserves) in a bid to prevent excessive rupee appreciation. 

Unfortunately, the tables have now turned. Thanks primarily to the rise in global oil prices from mid-2017, our CAD, which had all along been in the range of 1.5 per cent of GDP, began to widen. At the same time, demonetisation and the introduction of the GST took its toll on economic growth. The India story began to look less rosy. 

If that was the situation on the domestic front, in the US, interest rates continued their upward trajectory. The Federal Reserve Bank has already raised interest rates twice since January and could well raise rates four times in 2018, as against the earlier expectation of three rate hikes.  

The combination of higher interest rates in the US and a strong US economy (strengthening dollar) has already seen a flight of capital from all emerging markets, including India. Add to that the steady worsening of our macro-economic fundamentals, especially CAD, and it is no surprise that overseas investors have pulled out $48,000 crore in the first half of the calendar year. 

This is the highest outflow in the comparable period during the past 10 years. Worse, it is higher than the outflow in all of 2008, the year of the global financial crisis, following the collapse of Lehman Bros. Clearly, for the talk of India re-emerging as the fastest growing economy, with GDP growing at 7.7 per cent in the January-March quarter, the India story is fast souring as far as overseas investors are concerned. 

At the best of times, a net outflow of capital is bad news for India, given that we are overwhelmingly dependent on portfolio flows to finance the CAD. But when outflows are of this magnitude (and likely to increase) and come at a time when the CAD is likely to widen further, it is incredibly difficult to predict the tipping point at which the flight of dollars could become an unmanageable flood and result in a sharp fall in the rupee.

Rewind to July-August 2013. The mere hint from then US Federal Reserve chairman, Ben Bernanke, that the US was toying with ending its easy monetary policy was enough to lead to a flight of dollars from India and a dramatic fall in the rupee — Rs 57 to over Rs 68 to the dollar in just three months before the RBI stepped in with a host of emergency measures, including a 300 basis points increase in interest rates to stem the outflow.  

We can take comfort in the fact that our macro-economic fundamentals are in better shape than in 2013. We also have higher forex reserves — over $400 billion. Hence, there is no need to fear a repeat of the ‘taper tantrums’ of 2013. But that is cold comfort. Currency markets, like all financial markets, tend to overshoot. Worse, a disorderly fall in the rupee discourages capital inflows. As overseas investors, fearing a further weakening of the rupee will make their Indian investments less attractive, the RBI will have to hike interest rates sharply to attract inflows — with adverse repercussions for the nascent economic recovery. 

A weaker rupee also pushes up the price of all imported goods, especially oil, adding to inflationary pressures. If the government, bowing to populist pressure, tries to keep oil prices under check through subsidies, the fiscal deficit will be affected adversely. The fall in the rupee suggests a deeper macro-economic fragility.