How to Manage the Indian Rupee?

The Indian Rupee is in a free fall; 2013 redux, cry the opposition while the BJP ducks the criticism under the smokescreen of better macros: fiscal deficit of 3.3% of GDP in 2018-19 versus 4.8% in 2012-13 & inflation of 3.7% now vis a vis over 10% in 2013.

The fall in the rupee is due to the usual suspects:

(a)Increase in rates by the US Federal reserve that reduced the attractiveness of investing in the Indian markets with Investors seeing the interest rate risk premium offered by Indian markets as inadequate.

(b)The rise in oil prices: Since India imports over 80% of its annual oil requirements, an increase in oil prices increased the trade deficit & hence the current account deficit (CAD); CAD has increased from 0.6% of GDP in 2016-17 to 1.9% in 2017-18 & is likely to touch 2.8% in 2018-19.

Unlike the 2013 crisis which was during the period June-Aug, there is now a liquidity crisis, too, in the market, since advance taxes were paid in Sept. The RBI thus was forced to handle the twin problems of Exchange rate & Liquidity.

The PM chaired a meeting to handle the crisis & announced 5 measures all of which were expected to yield a net inflow of $8-10 billion which was a pittance for a country with around $400 billion in foreign reserves. The initial plan asking private companies to raise $10 million, in External deposits, of 1 year duration, was unfortunate because it is short term & no sane company, because of patriotism alone, will raise external deposits, when rupee is in a free fall. Later oil companies we're asked to pick the tab & they will since they are govt. owned.

The other was a grand statement to reduce imports & increase exports. While the traditional economic logic is that a drop in the value of the rupee would boost exports & reduce imports, the same is not fully true.  India’s imports of oil are in-elastic while imports of coking coal inevitable due to lack of indigenous resources; normal coal would do with less imports if Coal India increases production & private players are allowed a free competition; however, pricing differential between players who won coal mines in auctions & those who have got captive sites, free, would be a problem. Likewise, efforts to reduce gold imports, in 2013, by increasing the customs duty to 10% led to an unintended spurt in smuggling & hence unlikely to be repeated. Reducing imports of electronic items is the only solution – vide increase in tariffs which could invite charges of protectionism, but if played well, especially, when the US-China trade war is underway, could help India attract some of the supply chains from the Chinese mainland exploring a de-risking strategy; however, it will only happen over a period of time.  Increasing exports, too, is time consuming & exporters are currently facing the constraint of delay in GST refunds affecting their working capital needs.  

As expected, the market perceived the measures as inadequate & the rupee fall persisted. The Public Policy Takeaway: The PM should not chair such meetings since it gives a wrong impression of a fully blown crisis beyond the capability of the Finance Ministry – RBI combine to handle; it heightens expectations & announced measures, if meek, triggers panic selling, creating a vicious cycle, leading to a perfect storm.

The best policy solution would have been to stop outflows by raising repo rate by 0.5% & RBI issuing a statement that further raises are possible, if need be, to send a warning signal to the speculators who are currently shorting the rupee. Instead the govt. increased interest rates on small savings schemes by 0.4%.The other solution would have been to push exporters to remit their earnings faster & announcing a policy measure to attract Chinese supply chains, to India, in the medium term.

However, industry does not want a rise in interest rates since debt servicing would become a problem;  RBI, initially used over $25 billion to sterilize the rupee, dropping our foreign exchange reserves to about $400 billion. The rupee continued to drop, though, because there is no attempt to plug a leaky bucket - which is a task a repo rate rise should have performed - & India was facing a liquidity crisis. There is now talk of NRI deposits or increasing FCNR rates, a repeat of Resurgent India bonds of 1998, Millennium India bonds of 2000 or the 2013 NRI bonds. Why these round about ways when a direct repo rate hike would have been effective? Plug the leaky bucket first.

If there is a leaky bucket & water is flowing out - akin to money flowing out due to higher interest rates in US - plugging the leak first to ensure no more water flows out - by increasing the repo rate -would have been a sane choice.  Adding, thereafter, water - NRI deposits, Millennium bonds etc. - to the extent of water already escaped to fill the bucket would have effected stability to the exchange rate. The govt., by concentrating on the latter alone, is obviously, staring at suboptimal outcomes.