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Recent Downfall of the Indian Rupee

Parthapratim Pal (parthapal@iimcal.ac.in) and Partha Ray (pray@iimcal.ac.in) are with the Indian Institute of Management Calcutta, Kolkata.

Assessing the trends in India’s balance of payments, it is argued that a combination of substantial trade deficit and a significant current account deficit financed predominantly by fickle portfolio investments could have made the rupee vulnerable to the moods of the global capital market. India’s huge dependence on oil imports along with high gold and electronic imports could also have played their roles in making the exchange rate volatile.

The exchange rate of the Indian rupee has always been an emotive issue in India and has often tended to have generated more heat than light. The current episode of the downfall of the rupee is no exception. After all, the movement of the Indian rupee/United States (US) dollar exchange rate from less than ₹ 65 in early April 2018 to almost ₹ 73 by the end of September 2018 has turned out to be substantial. Owing to the underlying issues, opinions in this context have a tendency to differ substantially. Is it entirely due to the global instability created by US President Donald Trump’s sabre-rattling of the trade war with China? Is it a result of the beginning of tightening monetary policy cycle in the US? Is it a reflection of the contagion of the crisis in Turkey? Or, is it an outcome of the inherent weaknesses of the Indian eco­nomy with high imports of gold and huge dependence on oil?

Dollar Strengthening

There is a view that the depreciation of the rupee has been the result of a general appreciation of the dollar across all currencies. This appreciation of dollar is a fallout of the tightening of monetary policy by the Federal Reserve (Fed) in recent times. During the financial crisis of 2006–08, most developed countries, including the US adopted an expansionary and accommodative monetary policy which led to a nominal depreciation of the dollar. But, over the last year, the US economy has been showing signs of healthy growth. The job figures are pointing towards historically low un­employment figures and the gross domestic product (GDP) is poised to grow close to 3% in 2019 (IMF 2018). Consequently, the US Fed has started pushing up the reference interest rates and with the recent increase on 26 September, the benchmark rates have crossed the 2% mark for the first time since 2008.

It noted,

the labor market has continued to strengthen, and that economic activity has been rising at a strong rate. Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Household spending and business fixed investment have grown strongly. (US Fed 2018)

This monetary tightening by Fed is a key factor which is leading to a general appreciation of the dollar across all major currencies. Other policies like loose fiscal policy and increasingly protectionist trade measures are also helping the rise of the dollar (Ahmed and Thorne 2018).

But, the downfall of the rupee is not
limited to the dollar. In fact, the rupee has indeed depreciated with respect to all four major currencies since April 2018 (Figures 1A and 1B). However, it is
important to highlight that the recent slide of the rupee has been sharper than most other currencies from the emerging market with the exception of the
Argentinian peso or the Turkish lira. In fact, this year, the rupee has depreciated by 12% against the dollar which makes it the worst performer among the Asian countries (Patnaik 2008).

Nominal and Real Rates

But, what is influencing the value of the rupee? Is there any disjoint between the real and nominal exchange rates of the rupee? The monthly six-country trade weight-based nominal and real effective exchange rates (NEER and REER) of India since April 2015 (Figure 2) were examined and admittedly, the REER and the NEER have not always moved together since April 2015. Several phases can
be discerned.

(i) For the period from April 2015 to January 2016, the NEER depreciated but the REER remained largely stable. (ii) From February 2016 to April 2017, it appears that both the NEER and the REER were showing an appreciating trend. (iii) From April 2017 to December 2017, the trend of the first period was repeated, that is, the NEER declined but the REER remained stable. (iv) Since December 2017, there has been a steady decline of both the REER and the NEER.

What is also notable from the graph is that despite the sharp decline of the REER, its value in August 2018 is still higher than what it was during February–June 2016. It is possible that in real terms, the present slide of rupee may be partly due to a correction of a phase of nominal and real appreciation it experienced in 2016. However, the current depreciation of rupee with respect to dollar is sharp, and there are mounting pressures both from the current and the capital accounts, which are posing serious challenges for policymakers.

Widening Current Account Deficit

But, is the downfall of the rupee a mystery? After all, traditionally India has been a current account deficit economy and the current account deficit has increased sharply over the last few quarters. While the average quarterly current account deficit for the four quarters of 2015–16 was around $5.54 billion, the average current account deficit for the last three quarters (2017–18: Q3, 2017–18: Q4 and 2018–19: Q1) had reached $14.2 billion (Table 1). This rapid rise of current account deficit in the last three quarters can be largely attributed to the rapidly growing deficit in merchandise trade. While the balance of trade in services has remained strongly positive, it has been showing a stagnating trend since Q1 of 2015–16. Net private transfers (mostly remittances) have remained resilient over the same period. Stability of remittances perhaps indicates that despite a widening current account deficit, there was no widespread build-up of expectations of depreciation of the rupee. Generally, an expectation of depreciation among the expatriates can lead to a temporary drop or even reversal in remittances flow. This has happened before in India. Despite a growing current account deficit, such a trend is not evident from the data this time.

How does India’s current account deficit look vis-à-vis other comparator economies? It is well known that most of India’s East Asian neighbours, led by China, tended to follow an export-led growth and industrialisation strategy, and consequently, countries like China, Malaysia and Thailand have current account surplus (Table 2). Russia, of course, has current account surplus because of oil. Among other BRIC (Brazil, Russia, India, and China) countries both Brazil and India have current account deficit. Two key points need to be noted here. First, notwithstanding recent deterioration in India’s current account deficit, the situation is not as bad as the one during the period of taper tantrums. Second, India’s situation is clearly not comparable to Turkey.

Is Oil the Villain?

This worsening merchandise trade balance is driven by massive increase in the oil import bill, followed by imports of electronics, gems and jewellery (including gold) (Figure 3). It is important to note here that in all these three categories, there are some imports which are not meant for the domestic market. Some amount of imported crude oil and gold (and precious stones) is used eventually for exports. On the other hand, in the case of electronics imports, a percentage of intermediate goods are used as components in domestically manufactured final products.

A further decomposition of the merchandise trade data for the period April 2014 to August 2018 shows that India’s oil trade deficit improved from April 2014 to about February 2016 on account of favourable international oil prices. During January and February of 2016, oil prices were at a record low level, touching $28.08/barrel and $30.53/barrel respectively.1 As oil prices went up, India’s oil trade deficit also moved in tandem (Figure 4A). Interestingly, there is a strong (negative) correlation between the international oil prices and India’s oil trade balance (Figure 4B). Rising oil price poses a big risk for the Indian economy. As the Economic Survey 2017–18 pointed out,

It is estimated that a $10 per barrel increase in the price of oil reduces growth by 0.2–0.3 percentage points, increases WPI inflation by about 1.7 percentage points and worsens the current account deficit by about 9–10 billion dollars. (GoI 2017)

This increase in oil prices is likely to persist because some of the world’s major oil suppliers are facing sanctions from the US. These two countries, namely Venezuela and Iran, are major suppliers of oil in the world. Oil exports from Iran will come under US sanctions from 4 November 2018 and oil supply from Venezuela is also dwindling at a rapid rate. Iran is one of the largest suppliers of oil in the world and it is the third largest source of oil import for India. If oil supply from Iran comes to an end, then there is likely to be even more pressure on international oil prices. The Organization of the Petroleum Exporting Countries (OPEC) has indicated that it is not going to increase production to compensate for the loss of supply from Venezuela and Iran. The Oil Market Report for September 2018 by the International Energy Agency (IEA) indicates that the demand for oil is going to be resilient in the near future. Given these developments in the global oil market, it is expected that oil prices will stay at a fairly high level in the short to medium term.

How would the current account deficit continue to be in the near future? Overall, the current account deficit is expected to remain high. There are reports that India’s current account deficit, which is around 1.9% of GDP in 2017–18, is expected to rise to around 2.8% in 2018–19 (Sikarwar 2018). To reduce the trade deficit, the government has increased tariff rates for several products, including some electronic items. These are non-essential items according to the government. However, as tariff rates for free trade agreements (FTAs) have not been changed, it is unlikely that this increase in most-favoured-nation (MFN) tariff rate will bring down the volume of imports. But, it may lead to a shift in the source of import from the non-FTA countries towards the countries with which India has FTAs. Rupee depreciation, however, can be a more universal deterrent for imports as it affects imports from all sources. It also benefits exports by making domestic goods cheaper in terms of international currency. However, by raising domestic prices of imports, rupee depreciation can also lead to inflationary pressures. It increases prices of all imported goods, including oil and other intermediate goods, and thereby, can adversely affect the competitiveness of the country. The net effect will depend on import intensity and the price elasti­city of demand for India’s exports.

Outflow of Short-term Capital

Since the liberalisation of capital flows in 1991, India has always faced a current account deficit but inflows of capital have allowed the country to have a stable balance of payments (BoP). However, it appears that this time a rising current account deficit is also being accompanied by capital outflows. The bigger problem is that most of the factors driving these imbalances (like the oil prices, global tensions and the US monetary policy) are not under India’s control. And given such a perfect storm, it is only natural for the rupee to depreciate.

Perhaps, in consonance with the increasing monetary policy rate cycle in the US, the foreign portfolio investment (FPI) flows have become markedly more volatile in the last few quarters. If we look at the period from September 2017 to September 2018, the net foreign institutional investor (FII) flows have been negative in seven months and the FIIs have taken out more than ₹ 35,700 crore from India (Figure 5). In September 2018, more than ₹ 21,000 crore have been withdrawn by the FIIs on a net basis.

In general, emerging markets are facing outflows of capital due to increased tension about trade wars, external imbalances and commodity prices. Increasing monetary tightening by the Fed, the rising rate of interest in developed countries, and the revival of growth in such economies are other possible reasons as to why capital is flowing out from emerging markets. As a result of gradual tightening of the Fed policies, “risk-free” return from the US government securities is increasing. This is prompting many global investors to look for a “safe haven” in the US, given the rising uncertainties of the global economy. In case of India, expectations about rupee depreciation, and rising instabi­lity of its financial and banking sectors are probably playing a role. Average corporate performance in the last few quarters may also be responsible for the withdrawal of FIIs from the Indian market.

RBI’s Intervention

While the Reserve Bank of India (RBI) does not target any particular level of exchange rate, it is well known that the RBI tends to intervene in the forex market in order to reduce the volatility.2 While intervention data on a monthly basis are available at a lag, the latest available data pertain to June 2018. Until June, the pace of the net intervention appeared to be modest (Figure 6A). There are unconfirmed reports that in recent times the RBI could have turned less aggressive in defending the rupee. This could have been prompted by an objective to allow the rupee to be closer to its REER. India’s forex reserves, however, are on a downward trend since late April 2018 and stood at a little above $400 billion as of end September 2018 (Figure 6B).

The Way Ahead

Where does the analysis lead us to? Three comments are in order. First, there is no mystery in the recent downfall of the rupee as it was predominantly triggered by global factors. Second, India’s huge dependence on oil imports and significant propensity for gold and electronic imports have turned out to be its Achilles heel. Third, while the situation demands serious attention, it is not as bad as in 2013 (Lakshmi 2013).

The RBI on 5 October 2018 decided not to react to exchange rate depreciation and kept the policy rate unchanged. This is in line with RBI’s philosophy of flexible inflation targeting and not to target any specific level of exchange rate. Viral Acharya, the RBI Deputy Governor in charge of the monetary policy reportedly said, “managed float is what roughly RBI’s policy is and what the RBI’s foreign exchange operations pursue” (Rebello 2018).

Although this does not seem to be a doomsday situation, India for long has been caught up with the tensions of the impossible trinity, whereby a country can have at the most two of the following three objectives, namely a fixed exchange rate, monetary policy independence and flexibility of capital accounts. The tension, in the case of India, is all the more pronounced in view of the following features of India’s BoP: a substantial merchandise trade deficit that is not being adequately compensated by software, and private remittances and the resultant current account deficit that is getting predominantly financed by fickle port­folio capital flows (being dictated by gravitational forces of risk-adjusted returns in the global capital market), and moderate but steady foreign direct investment. Any change in the global investment climate can seriously jeo­pardise this delicate balance. While these are more structural issues, and may call for a relook at India’s growth strategy as well as its approach to capital account liberalisation, it should suffice to state that the rupee will continue to be under pressure whenever the mood of global capital market changes, for it happened in 2013 and it can happen in 2018 as well!

Notes

1 The prices are for the “Indian basket” of crude oil which is a derived basket comprising sour grade (Oman and Dubai average) and sweet grade (Brent Dated) of crude oil.

2It is instructive to refer to the former Governor Jalan (2003) who said, “RBI does not have a fixed ‘target’ for the exchange rate which it tries to defend or pursue over time; RBI is prepared to intervene in the market to dampen excessive volatility as and when nec­essary; RBI’s purchases or sales of foreign currency are undertaken through a number of banks and are generally discrete and smooth; and marketoperations and exchange rate movement should, in principle, be transaction-oriented rather than purely speculative in nature.”

References

Ahmed, Saqib Iqbal and James Thorne (2018): “Trump and the US Dollar: Actions Speak Louder Than Words,” Reuters, 21 July, https://www.reuters.com/article/us-usa-trump-dollar-analysis/trump-and-the-u-s-dollar-actions-speak-louder-than-words-idUSKBN1KA2KK.

GoI (2017): Economic Survey 2017–18, Vol 1, Department of Economic Affairs, Ministry of Finance, Government of India, p 18, paragraph 1.52.

IMF (2018): “United States: 2018 Article IV Consultation Staff Report,” Inter­national Monetary Fund, Washington, DC: https://www.federalreserve.gov/monetarypolicy/fomcpresconf20180926.htm.

Jalan, Bimal (2003): “Exchange Rate Management: An Emerging Consensus?,” speech by the
Governor, Reserve Bank of India at the 14th National Assembly of the Forex Association of India on 14 August, https://www.rbi.org.in/scripts/BS_SpeechesView.aspx?Id=133].

Lakshmi, Rama (2013): “India in Uproar Over Rupee’s Fall,” Washington Post, 20 August, https://www.washingtonpost.com/world/india-in-uproar-over-rupees-fall/2013/08/20/975cad98-08c9-11e3-89fe-abb4a5067014_story.html?noredirect=on&
utm_term=.1f348b9a0dd1t
.

Patnaik, Ila (2018): “The Rupee Is Falling and India Should Let It,” 10 September, https://www.bloomberg.com/view/articles/2018-09-10/the-rupee-is-one-of-asia-s-worst-performing-currencies-this-year.

Rebello, Joel (2018): “Let Rupee Find Its Comfort Level: Viral Acharya,” Economic Times, 6 October, https://economictimes.indiatimes.com/markets/let-rupee-find-its-comfort-....

Sikarwar, Deepshikha (2018): “Minimum Import Price among Options to Curb Non-essential Goods,” Economic Times, 17 September, https://economictimes.indiatimes.com/news/economy/policy/minimum-import-price-among-options-to-curb-non-essential-goods/articleshow/65835916.
cms
.

US Fed (2018): Press Release, Federal Reserve, 26 September, https://www.federalreserve.gov/monetarypolicy/fomcpresconf20180926.htm.

Updated On : 15th Oct, 2018

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