Address Basics to Stem Rupee Slide

RASHESH SHAH

The recent depreciation of the rupee to historic levels has created a near-panic situation. Various solutions are being proffered: from interventions by the Reserve Bank of India (RBI) to curbs on forex outflows. But a calmer assessment of the situation should make it clear that the panic is misplaced and what is needed is deeper introspection. We need solutions rather than kneejerk reactions and short-term fixes. To understand the true depth of the rupees fall, it is important to look at its value in terms of real effective exchange rate (REER) rather in absolute terms. REER is a weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation. The weights are determined by comparing the relative trade balances, in terms of one countrys currency, with each other country within the index. Now, data from the RBI for rupees trade-weighted REER against a basket of six currencies reveals a different picture. Till end-October, the rupee had appreciated by over 8% over the average of 2004-05, and over 6% over the average of 2009-10. So, the fact is that the rupee was somewhat overvalued and its fall was a long-standing adjustment. In markets, sometimes the long-standing adjustments do not happen for a long time and then happen very swiftly. The problem is not so much the extent of the fall as the speed with it fell and the resultant volatility in the markets. But then, markets are like a pressure cooker. Every one hears the whistle and heads for the door. Very few people actually see the pressure building. The pressure has been building because the macroeconomic situation over the last couple of years has turned adverse and we have not taken enough steps to address the issue early enough. All the ingredients for the rupee fall have been there for some time: for the last year, portfolio flows have slowed down or even partially reversed, our current account deficit will shoot beyond the 3% target, the European crisis has reduced global liquidity, a lot of borrowings from 2007 are due for repayment now, our inflation has been high that has now reduced and FDI has slowed down significantly. So, rather than handle the rupee fall, we should try and manage the underlying causes that have led to rupee falling. The mid-year review presented by the government clearly points out the problems. GDP growth has fallen to 6.9% in the second quarter. Manufacturing has slowed down to 2.7% and construction to 4.3%, while sectors like mining have shown negative growth. Though the government forecasts an annual growth of about 7.3%, given the fact that the government has admitted that it seems difficult read: unlikely to meet its fiscal deficit target of 4.6% GDP this target frankly seems optimistic. Most of the underlying causes inflation, euro crisis, repayments, etc are either beyond our control or already being handled. So what needs to be done is: (a) give growth impetus as inflows will increase the moment confidence in our growth is back, (b) boost inflows, especially long-term flows, and (c) reduce foreign exchange volatility. For getting growth back, the script is becoming clearer: we need fiscal control and easier interest rate scenario. There seems to be a consensus that if interest rates are hiked any more, it will start affecting growth. This means that the responsibility of tackling inflation now rests with the government with fiscal measures. It needs to reduce the fiscal deficit and, at the same time, initiate supply-side reforms. This will get confidence in growth back.

We also need to boost inflows rather than impose curbs on foreign exchange outflow. Inflows are usually in three forms: short term, medium term and long term. Short term is usually debt and quasi debt. The RBI has already eased the curbs on such short-term lending to boost inflows. The mediumterm forex reserves essentially consist of portfolio inflows in the Indian stock markets. Last year has been bad for FII investments as we have seen net outflows. But once growth returns, so will the FIIs. FDI represents the long-term forex reserves. These can improve only if we start taking hard decisions about foreign investments. FDI has always been Indias relative weak point and we need to use the current exchange rate fall to correct this, because foreign investment without allowing majority controlling stakes is equal to portfolio investments. So far, policy ambiguity has led to investors postponing FDI investments. The reported reluctance of global investors towards investments in Indian infrastructure projects is also a case in point. Lastly, we need to ensure that rate adjustments are continuous and not have the kind of sharp volatility we have witnessed. This can be done by classifying our forex reserves in more granular terms and having a lot more information around kinds of flows, the composition of reserves, etc. More information and discussion would mean quicker shortterm adjustments rather than a huge pressure build-up and a large adjustment in one quarter. Also, promoting freer forex trading getting NDF markets onshore ideally having deeper and longer-dated onshore currency market, etc, will also give enough early warning signals. Sharp and unexpected rapid adjustments create panic, knee-jerk reactions and tend to be inefficient for the economy. No doubt these are tough times. And a lot of the above is easier said than done. But we should use the rupee fall as a catalyst to address deeper economic issues and get India on the growth path once again. But the margin for error is now small and getting smaller. We need to act now! (The author is chairman and CEO of the Edelweiss Group)