Policy intervention should ensure Rupee depreciation in a less disruptive way

By B Prasanna

The level of the rupee is always a passionately debated subject not just in the esoteric trading world but also in mainstream society.

The reason can simply be ascribed to how much the rupee affects all stakeholders in the community through the different value chains in the economy – importers, exporters, outbound and inbound financial investors, parents of students going abroad, travellers and last but not the least – the government.


It is hence not surprising that when the dollar-rupee pair reaches key psychological levels, all of them sit up and take notice. One such red letter episode occurred on June 28 when the rupee flirted with a new record low. We look at the various factors contributing to this weakness.

The first and the foremost reason is the widening trade deficit that is expanding at an alarming pace, thereby worsening India’s current account deficit (CAD) to more than $70 billion in FY19 as compared to lows of around $14 billion in FY17. On the trade account, sharp increase in oil imports due to elevated crude prices was inevitable.

However, on the non-oil imports front, even though gold imports have been contracting for the past few months, there has been no respite as other imports such as electronics have risen sharply. We also run a risk of gold imports picking up if rural consumption shows a significant fillip.

Secondly, the capital account is likely to reduce significantly in FY19 as compared to $92 billion seen in FY18. This combination is likely to lead to a deficit on balance of payments to the tune of at least $10 billion with strong upside risks on account of sustained FII outflows.

Current account deficit can be funded through stable or hot money flows. FDI would be the former and the basic balance of payment (CAD+FDI) is a good metric in this regard. This has swung from positive to negative in FY18 and is further likely to double in FY19, thereby underscoring the vulnerability of the funding situation. Last year, hot money flows have been plentiful, attracted by the relatively high real rates, thereby building a sense of complacency.

“Fickle” FPI investments, shortterm carry trades through exporters (by selling immediately) and importers (by delaying purchases), NRI remittances/deposits chasing (relatively) high domestic interest rates, corporates having ability (to seamlessly borrow short term either in the dollar or the rupee) choosing to fund through dollars were some of the reasons for the heavy inflows of the past. Now these excesses of the past are coming back to haunt us as dollar strengthens and becomes more expensive.

The pressure on FPI outflows is likely to continue as concerns about trade wars heat up globally. Additionally, the regulatory steps taken with regards to short-term trade credit is likely to sharply impact the loans category within the capital account.

The bigger worry on the capital account front is that of foreign direct investment, which is showing signs of slowing down.

There is now increasing noise of policy intervention to stem the rupee depreciation in the form of incentivising NRI deposits. In 2013, the FCNR (B) scheme helped to stall what was becoming a free fall of the rupee and stabilised our vulnerable macroeconomic position. Cut to 2018, and the situation is very different. Our macroeconomic backdrop is far stronger, we have much higher forex reserves and the pace of depreciation this time has been fairly calibrated.

As such a 2013 redux would only serve to portray an environment of panic, which is unwarranted. Also on the cost front, apart from the direct cost of subsidising the scheme, there is also an indirect, long-term cost of artificially revaluing the currency, which impacts our competitiveness. On the basis of inflation differentials and valuation metrics, part of this depreciation is justified.

Policy prerogative should be to ensure that the process occurs in as less a disruptive manner as is possible.

Forex reserves of more than $400 billion is certainly comforting but faced with strong headwinds of the yuan depreciation, high crude prices, FPI outflows and increasing possibility of tail risk events, just the quantum of reserves cannot be seen as a bulwark against these adverse forces.

However, while we do believe that the rupee is on its way towards 70 handle, it might just be a matter of time before the dollar’s own fundamentals (twin deficits) start weighing on it to reverse course. If that does happen with full might, we might not need the abnormal solutions like NRI deposits after all.

(The writer is Head-Global Markets Group, ICICI Bank)