The Indian rupee has lost more than a quarter of its value since the beginning of US rating downgrade (August 2011-June 20, 2012). The slide in May 2012 has been precipitous, with the rupee losing 6% of its value. The rupee did stabilise for a while in the first half of June 2012, but on June 22, 2012, the rupee closed at 57.15 to dollar. This decline was surprising, because as we will shortly see, the real effective exchange rate (REER) index do indicate that the rupee was fairly valued at roughly 56. The subsequent decline has more to do with the current domestic scenario. In principle, in this piece, we try to debunk a couple of myths, namely that the fall in rupee value is because of the euro crisis and that the rupee has been the worst performing currency among the emerging economies. We also answer the questions on what could be a fair value of the rupee, the possible reasons for the slide in rupee value and the similarities (or otherwise) of the current situation with the 1991 crisis.
To begin with, the oft-repeated myth is that the recent disturbances in the rupee value is mostly because of the euro turmoil. As Table 1 shows, there are two reasons to believe that the euro crisis is not driving the free fall in rupee value.
First is the absolute level of claims of European banks on South Asian economies, including India. Second is the decline in liabilities of the European banks on such economies in 2011. Both these factors should result in weakening of the domestic currency. As far as the first point is concerned, even though countries like Malaysia, Korea and Thailand had significant bank exposures, the pace of currency depreciation was much lower than India. For example, Malaysian banks’ exposure was at 20.3% of GDP but its currency depreciated only by 7% during August 2011-June 20, 2012. On the other hand, Indian banks’ exposure was at 7.2% of GDP but the rupee depreciated by as much as 27% during the same period. Secondly, the extent of deleveraging is higher for countries like Thailand and Philippines as compared to India during 2011, yet, the extent of currency deprecation is much smaller for these countries compared to India. Clearly, the euro crisis is not the reason for rupee decline.
The second myth that various analysts point out is that the Indian currency is the worst performing. This is not entirely correct. For example, in May 2012, rupee declined by 6%, but the decline was still less than the slide of currencies of Brazil, South Africa and Russia against the dollar.
We believe that movements in India’s balance of payments (BoP) have been the primary reason for decline in rupee value in recent times (refer Exposition 1). In particular, BoP has been in deficit mode in FY12, with an ever increasing trade deficit (at 10% of GDP). The deterioration in BoP had also been aggravated by a concomitant decline in capital flows, reflecting perhaps a loss of investor confidence. Clearly, the decline in rupee value is attributable to structural factors that may be specific to India!
Ever since the rupee has started sliding, several theories are floating around regarding the correct value of the rupee. The six country REER is now nearly at 100 (as at end May 2012, it was overvalued by just 0.1% against neutral REER). A back of the envelope estimation suggests that this translates into a nominal rupee value of 56 at its long-term competitive value. Alternatively, any further decline in rupee value from the current level would be an instance of undervaluation.
However, a point of caution here for the policymakers. There was a sharp jump in REER from April 2010, reflecting perhaps the spike in inflation to double digits during this period. The REER has been on a declining trajectory, and more so, since November 2011, reflecting a downward trend in inflation. Given that the inflation rate is projected to decline to 6.5% by March 2013, as per RBI projection, the REER may decline further indicating the scope for rupee to appreciate from the current levels. From that point of view, there is indeed a scope for the rupee to appreciate from the current long-term competitive value.
The current situation is somewhat analogous to 1991 (refer Table 2). Indicators of vulnerability on external sector show a significant increase, in some cases approaching the levels of 1991. For example, India’s current account deficit (CAD) to GDP ratio is at 4%, close to the levels seen in countries affected by the East Asian crisis (Indonesia at 3.5%, Korea at 4.8%) and higher than the 3% level of crisis-hit India of 1991. However, import cover and debt service ratio are still at comfortable levels now.
To sum up, we think the recent cues suggest that the rupee may have already touched it lows, and there is a definite scope for a rebound. However, for that to happen, risks remain with regards to uncertainty regarding redressal of domestic policy related issues. The slide in rupee value is more a reflection of domestic economy fundamentals, and a slowdown in pace of policy reforms. The government has already taken the initiative of turning the policy wheels, by announcing the much expected hike in petrol prices. However, this reform has to be taken forward by raising diesel and LPG prices (diesel accounts for nearly 60% of the under recoveries of the oil marketing companies) as well as initiating pending reforms in several other sectors.
On the whole, even though the RBI has limited ammunition in terms of foreign exchange reserves to ward off the decline in rupee, there may be several policy options that it may consider as a proxy for indirect intervention measures (other than dollar sales). One such could be similar to the move in 2008: the RBI could conduct special market operations for oil companies, holding auctions to buy oil bonds and giving the oil companies dollar at market rates. The RBI may also choose to make explicit press statements talking up rupee, as research suggests that such a signalling mechanism has an immediate impact on market sentiments. In the long term, the government much initiate policy reforms to encourage capital inflows by reducing the withholding taxes on FII, allow FDI in multi brand retail and liberalise FDI in aviation and insurance. The RBI and the government may also mull a bond issue along the lines of India Millennium Deposits. In essence, the government should try and move ahead of the curve to win back investor confidence as otherwise, there will no light at the end of tunnel, as far as rupee depreciation is concerned.
1 Dr Rajiv Kumar relinquished his position has Secretary General, FICCI on October 23, 2012. Dr A Didar Singh took charge in his place on November 01, 2012.