Given the relative calm in USD/INR between 2014 and 2017, the current rupee depreciation feels painfully sharp.
USD/INR Move In Perspective
Yet, we are not in an uncontrolled USD/INR free-fall, irrespective of what news headlines might suggest. Unlike 2013, the Reserve Bank of India (RBI) still has ample currency reserves to be in control - for now.
The current situation is closer to 2011-2012 when RBI’s currency reserves were still enough to buy us time to address core imbalances.
That means that there is no real reason for panic just yet. But neither should we feign helplessness, and blame the current context on external events alone.
Instead, we must recognise that there are issues of financial stability – the quality of our external balance, the health of our financial services industry, and the quality of our fiscal health – that can and should be addressed urgently. We can and should avoid any risk of a repeat of 2013.
So Where Will The Rupee Settle?
For now, all eyes are on the RBI. At $400 billion, RBI has ample currency reserves to manage short-run volatility.
Earlier, between April and June 2018, RBI sold $25 billion and held the line for USD/INR at 69.00. When Turkish Lira erupted in August, RBI withdrew from that frontier, and USD/INR is now skirting 72.00.
Will RBI hold rupee for now? Or will it allow some more depreciation? Since RBI does not have a publicly articulated currency management framework, we can only hazard a guess.
Personally, I think RBI should step in and draw a fresh line around here, at least for now. While some correction in rupee overvaluation will help improve our current account deficit, too rapid a fall in currency is just not helpful – neither for trade and capital flows nor for sentiment.
Sustained, near-panic demand for USD emerged ever since the RBI allowed USD/INR beyond 69.00. This underscores the tough job RBI has of finding the Goldilocks balance between the extent and pace of depreciation, and extent of intervention dollars that need to be used.
There will be time later to critique RBI’s foreign exchange management framework. For now, we have to trust the RBI to do the right thing.
In the meantime, Delhi and Mumbai should coordinate on any market-related communication. As things stand, Mint Street will not talk, while North Block will not stop talking about markets. It might help to switch roles now.
I Didn’t Do It
Our national motto at the first suggestion of a crisis invariably tends to be “I didn’t do it”. We saw this in 2011-2013. Sadly, we are seeing it now – the blame lies with Turkey, Argentina, Trump, Iran and Twitter – on anyone but us.
Yes, external triggers do spark crises at home. However, when those sparks arise, we are sometimes caught sitting on a powder keg of financial instability, largely of our own making.
We have our share of explosive financial stability issues today that we should address urgently.
Addressing Our External Imbalance
The first powder keg is the nature of our external balance. Between FY15 and FY18, our inflation-targeting framework kept real interest rates high, and this attracted $120 billion of carry-seeking inflows. This included Foreign Portfolio Investment (FPI) in debt, net exporter hedging, uncovered external commercial borrowings (ECB), and other speculative positions. While adding to RBI’s currency reserves, these resulted in significant overvaluation of the rupee.
Partly because of this overvaluation, our current account deficit (CAD) started to move up sharply, from $15 billion in FY17 to $49 billion in FY18, to an estimated $80 billion in FY19.
There are other issues though, besides rupee overvaluation and a rising oil bill – our exports and manufacturing sectors have struggled, while our demand for smartphones has continued to grow.
In effect, we are now borrowing fickle, opportunistic, expensive foreign currency to pay for our rising oil, electronics and gold bills. This balance is just not healthy or sustainable and needs to be addressed.
Rupee depreciation should, over time, reduce some of the current account deficit. But the onus still lies elsewhere – we must address issues faced by exporters and the manufacturing sectors, and make both Make in India and Make for India work.
Experts from the industry have made many suggestions in this regard, and these need to be considered and implemented.
Addressing Our Internal Balance
In order to revive the investment cycle and to attract sustainable, high-quality capital inflows, the health of our financial sector and the nature of our fiscal balance need to be addressed as well.
Stressed financial sector balance sheets remain the soft underbelly of the Indian economy. We continue to kick the can down the road on complete bank recapitalisation, resolution of stressed assets, and most importantly, reform of the banking sector.
Likewise, our fiscal balance looks tricky. While the overall central fiscal deficit was under control at 3.5 percent in FY17 and FY18, the quality of the deficit deteriorated. Our revenue deficit rose from 2.0 percent of GDP in FY17 to 2.6 percent in FY18 and could slip even more in this election year FY19.
Our absolute capital spending reduced from Rs 2.90 trillion in FY17 to Rs 2.64 trillion in FY18. We are borrowing long-term money and reducing capital investments, to pay for current budgetary spending.
Particularly as external vulnerabilities mount, it is vitally important that issues around our financial services ecosystem and fiscal balance are addressed.
RBI has ample reserves to control short-term currency volatility. It can buy us time to address our core imbalances. Within this time period, issues around exports and manufacturing need to be addressed. Alongside, to bring in quality long-term inflows, we must improve the health of our financial services sector, and the quality of our fiscal balance.
Ananth Narayan is Associate Professor-Finance at SPJIMR. He was previously Standard Chartered Bank’s Regional Head of Financial Markets for ASEAN and South Asia.