The Frail Indian Rupee

by Shashank Pasrija on July 1, 2013

RBI

The Indian Rupee hit a record low against the U.S. Dollar recently. While this is good news for exporters—particularly Indian IT companies—it has the Indian Central Bank worried. There are a number of reasons for the decline, but a look at the three key factors responsible for the depreciation explains how the currency is unlikely to get back on track anytime soon.

High Current Account Deficit

Recently, India has been running a historically high current account deficit that is close to five percent of the GDP. While the latest data has shown some improvement in the deficit, it continues to be driven by the perennially large imports of oil and gold without any growing offset in exports or investments. The policy paralysis that has plagued the current government, coupled with a weak global economy, will result in continuation of sluggish exports and investments. On the import side, falling gold prices and recent regulation to curb gold imports have made a small dent but now offer limited room to maneuver. A weak Rupee is likely to result in increased remittances, but they alone are not enough to tide over the hardships. Thus, in the absence of major policy intervention, unless there is a sudden drop in prices of oil or the government adopts harsh but unpopular import restrictions—both unlikely possibilities—the current account deficit is likely to remain high.

Stubborn Inflation

An aggressive monetary policy predicated on high interest rates has helped the Indian Central Bank bring down inflation from over ten percent to a more bearable rate of below five percent. However, this has come at the cost of growth, negatively affecting the appetite of foreign entities to invest in India, thereby reducing capital inflows. Of greater concern are the structural weaknesses in the economy—owing to low development and poor infrastructure—that drive inflation. Even today, the amount of rainfall received has a significant impact on the policies of the central bank in India. It is likely that any reduction of key policy rates will result in untamed inflation yet again. Given that these structural issues can only be resolved in the long term, unfortunately a tight monetary policy and all of its consequences present the most viable way to keep runaway inflation in check.

Bounce-back of the U.S. Economy

The recent improvement in economic indicators for both GDP and jobs in the United States has helped lift sentiments. It has also allowed the Federal Reserve to suggest a slowdown of its bond-buying spree, thus strengthening the dollar. It is likely that investors could renew their interest in a resurgent U.S. economy by redirecting capital flows from riskier markets like India. While the fragile U.S. recovery is still at risk of derailment, a continuation will likely result in a weak Rupee despite any increase in exports to the United States owing to the recovery.

In addition to these three main factors, the upcoming national elections in 2014 are likely to have a negative impact on the Rupee. As the elections draw near, an embattled government is likely to resort to populist measures resulting in negative economic implications. At the same time, a dwindling level of foreign exchange reserves means that the central bank has only limited room for intervention. While it could reduce the volatility in the movement of the Rupee, it is unlikely to have the capacity or the intent to change the overall trend.

However, there exists a silver lining to this dark cloud of monetary doom. First, the star performer of the Indian economy—its IT industry—has benefitted from this depreciation. Recently, the Indian IT industry has had to deal with shrinking revenues and the possibility of unfavorable regulations owing to poor global economic conditions. The Rupee’s depreciation has come as a welcome relief to the industry and the thousands of masses it employs. Second, the depreciation is likely to force the government to hasten existing reforms to encourage investments. While the popular adage, “India never misses an opportunity to miss an opportunity” is hard to shake off, the liberalization of the Indian economy was a result of a balance of payments crisis in the 1990s. The current hardship, while not as severe, will pressure the incumbent to adopt more prudent economic policies.

Given the formidable challenges, it is unlikely that the Rupee will start gaining ground steadily anytime soon. For things to improve, the government should focus on deregulation and divestment in the short term. In the long term, it should focus on removing hurdles to businesses, such as poor infrastructure and governance, while promoting new areas for exports, such as manufacturing. In sum, there is much work to be done before the Rupee can come into a lasting position of strength. One can only hope that the Indian government does not get too complacent about the plight of its frail currency.

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