With tapering looming on the horizon, and many observers predicting the Fed to start hiking interest rates very soon, the rupee has been plunging downwards to record lows. Low interest rates in the US have long been a major reason why liquidity has flowed into emerging economies, but the tide could now be turning.
India and the rupee are particularly vulnerable to the change in expectations, due to its sizeable current account deficit amounting to $18.1bn in Q1, and $31.9bn in the previous quarter (equal to 3.6% of GDP and record 6.7% of GDP). Concerns that India will not be able to fund the shortfall through capital inflows, such as foreign direct investment, result in depreciation of the currency.
Especially large imports of crude oil have raised some alarm, seeing as oil prices react to events relating to Syria, and with India importing nearly 80% of its oil, it is in a highly vulnerable position, where higher oil prices would lead to higher inflation and thus larger current account deficit.
US Dollar to Indian Rupee exchange rate. Source: Bloomberg.
At this point, the rupee has lost 20% of its value in 2013, making it one of the world’s worst-performing currencies. According to Vishnu Varathan, economist at Mizuho Bank Ltd. “this is unprecedented, and we are in uncharted territory for the rupee,” adding that he expected the rupee to fall to the 70 mark against the US dollar. In vain attempts to stop the rupee from sliding, the Reserve Bank of India (RBI) has implemented various measures, such as
- restricting the sums that companies and individuals may send out of the country
- increasing the duty on gold imports three times in 2013
- increasing the RBI’s interest rate on lending to other banks and capping banks’ daily borrowings
while nevertheless having the nerve to deny that any of these amount to real capital controls: “There is no question of us putting any restriction on outflows… There is no control of outflows of dividends, profits, royalties, or on any kind of commercial outflows”, according to Department of Economic Affairs Secretary Arvind Mayaram. “With rising NPAs, corporates are getting more and more into difficulties… So looking into their balance sheet before they are allowed to invest abroad is all that has been proposed. Hence, it is not capital control”. Furthermore, Mayaram argued that “Gold, silver, platinum are what we believe as non-essentials. We have put curbs on that”.
Despite the unwillingness to call capital controls by their real name, RBI worry is even clearer in another attempt at stopping the rapid depreciation, namely a pilot project that will be launched soon, according to a source familiar with the RBI’s plans to curb the plummeting currency. This project has the stated goal of making Indian banks buy up gold from private households.
The RBI will ask the banks to buy back jewellery, bars and coins for rupees, because the 31,000 tonnes of commercially available gold in the country – worth $1.4 trillion at current prices – could patch up the current account, even if only some of it was bought up. India imported 860 tonnes of gold in 2012 alone, and the hope is that if a little of that privately held gold is monetized, the current account deficit will be taken care of.
This idea completely ignores the fact that Indians buy gold to get out of the rupee. Specifically, Trade Minister Anand Sharma said that in a country with 31,000 tonnes of declared gold “even if 500 tonnes is monetized at today’s value it takes care of your current account deficit”.
At the end of the day, capital controls by alternative names and gold monetization schemes do not resolve anything, so long as India’s current account deficit remains as gaping as ever. Little will change, and the rupee will suffer. The Banyan blog on the Economist lists three options for the Indian government:
- let the rupee fall further. Most countries like a cheap currency, since it boosts exports ceteris paribus, but in the case of India, its industry is too small and too bound in red tape, so a weaker currency may add to inflation and to subsidies, worsening the current account deficit.
- increase interest rates like Brazil and Indonesia, to attract more foreign money. This, however, will hurt domestic industry, which is already struggling, and probably increase bad debts at banks too. Inducing a credit crunch in India might make things even worse.
- lower government borrowing, currently at 7% of GDP. The populist political mood does not make big spending cuts easy though, and in fact, India’s central government has a pretty low expenditure relative to GDP of 15%. More tax revenues is a better choice, but with only 3% of Indians paying income tax, this probably means concentrating tax rises on the formal economy, which is already reeling.
India is in dire straits, and just how far the rupee will fall is yet to be seen.
