On 15 July 2010, the Indian rupee got a symbol of its own. Many Indians felt proud that their currency now had a visible identity. The exercise itself represented a great triumph, many crowed at the time. It was a democratic process. The government invited submissions from everyone.
A young designer won the contest. It was seen as yet another step in the march towards the global high-table for India. Since then, things haven’t been going well for the rupee. As we write, the rupee is bouncing around just under 60 to a dollar after the Fed’s announcement of tapering bond purchases.
Our current predicament raises to several questions.
How did we land in such a situation? Who is to blame? Is the slide over? What should be done to retrieve the situation? Where do we head from here?
It is a well known fact that a person who is really in need of money seldom finds a lender, but a person who does not need to borrow will have lenders queuing up to lend. Like it or not, we unfortunately have landed in the situation of the former, where our imports have to be funded out of portfolio flows, foreign direct investments and external borrowings.
All ills of our currency begin with our negative current account balance. Current account is broadly the sum of the balance of trade (exports minus imports of goods and services).
As can be seen from the chart CAD out of control, we have always been running a negative balance in our current account. It is only in the years following the financial crisis in 2008, that the situation has worsened as the slow down hit the developed world resulting in lower trade flows.
The reasons for the bugling current account deficit (CAD) are well documented. Most analysts have pinned the blame on gold import. As a matter of fact, among the import items, there is very little that can be done to reduce demand except clamping down on gold.
While the obvious solution is to increase exports, it is easier said than done. It just cannot be done in the short run and given the way our democracy functions, precious little gets done to debottleneck and encourage exports. In fact for a country persistently facing CAD problems, the measures one gets to hear about rarely exceed some subsidised credit scheme or the other. Sadly the state of affairs is unlikely to change.
The moment pressure eases on rupee all the reforms will be put on back burner till the next round of panic.
As gold stands out as one of the main culprit, here’s a suggestion. Over 40% of the gold imported is in form of bars and coins. This segment obviously is not emotionally attached to their gold holding and hence logical to expect these to come to market if conditions were right. Given the size of holding, a good part of consumption demand should be met from this source.
One reason why this does not happen is because of transaction cost, or the bid ask spread quoted by jewelers, which make it very costly to trade. Next is lack of transparency in price discovery. One solution which has been suggested earlier is to allow banks to make two way quote for gold with transparent spreads and encourage holders of gold to trade.
This should result in monetization of at least part of gold holding and result in flow of domestic gold into market, at least when prices are high.
Coming to the question of who is to be blamed, we would leave the reader to draw their own conclusion. The immediate triggers for the slide were:
1.USD strength against emerging market currencies on account of “tapering”
2. Importer demand
3. Flight from Indian bonds, as hardening US yields reduced attractiveness of Indian bonds, which were in any case a tempting sell after spectacular rally of over last two months.
There are no quick fix solutions to CAD problem. Hence what authorities do is to figure out how to fund the deficit. In this regard they have been doing all the right things like inviting sovereign wealth funds among other investors to come and invest, doing away with proposed offending FII specific tax laws etc. For sustained portfolio flows, the key is to revive growth.
The reform measures underway obviously are the right things to do, but the problem is the snails pace at which we are moving. A stubborn Central bank, who had been once cajoled in to keeping loose policy for too long refuses to do its bit. In this background, there is no escaping the ebb and tide of global liquidity flow.
What is aggravating the volatility is the incomprehensible utterances at various times and forums of Ministry of Finance officials, economic Advisors and even the Governor himself. If their objective was to devalue the rupee, they could not have done a better job.
While it may be true that the ammunition may be limited to fight the speculative onslaught, there simply is no reason to say publicly that we are not capable of defending rupee! Stating that the central bank will not intervene is akin to surrender even before the battle has begun.
There is a good chance that rupee would have still weakened to the level it has, but the fall would have been more gradual and therefore manageable, had the players been wary of central bank intervention along the way.
As we mentioned earlier, the current bout of weakness was triggered by the Fed announcement on tapering off the bond purchase. If it actually happens, the actual impact may not be significant. Most likely the liquidity glut would continue even after the Fed stops buying bonds. However hardening US bond yields (as a consequence of tapering or in anticipation of tapering) would put pressure on all asset prices.
It is more than likely that a route in asset prices most probably would put immense pressure on Fed to think of some other plan to re-infuse liquidity. In view of past experience, it would be safe to say, sooner rather than later, Fed will give in to market forces.
Till then however we have to bear the weakening bias. On real effective exchange rate (reer) published by rbi, at the current levels we already are undervalued. At some point there could be some mean reversion to appropriate value, but in the mean time, the technical targets are in the region of 60.30-60.80 and further down at 64.80.
In view of experts such as SS Tarapore, the level at which the rupee should make a meaningful impact on cad is around Rs 70 to the dollar. If the weakening rupee is inevitable, we may be lucky that it is happening when the inflation outlook appears benign. Thank heaven for small mercies.