Rupee – A new normal?

The fall in the value of the Rupee is not all bad, and industry may have to adjust to a new normal level, says Pranav Kumar

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the Indian economy looked to be in the pink of health not very long ago and everything seemed to be growing upwards. Even as the developed markets were sinking, India grew smartly during 2009 to 2011, helped

by its strong domestic economy. But soon after, things began to unravel. In each of the four quarters of the previous fiscal, economic growth was lower than the previous one. The overall growth (revised) in FY12 was 6.5 per cent, down from 8.5 per cent a year ago. GDP growth in the last quarter of the previous year in particular, stunned everyone at just 5.3 per cent. As usually happens, in an economy that has fundamental weaknesses, cracks show up in multiple parameters, as these are inter-linked. Thus, bad news has cropped up in many areas – from inflation to interest rates, fiscal deficit, current account deficit, and the exchange rate. Perhaps it is the fall in the value of the Rupee, which has been the most spectacular of all. The Rupee fell nearly 25 per cent against the dollar in just six months, earning the dubious distinction of being one of the worst performing currencies in the world. Only a few days ago, it touched its life-time low going below Rs 57 to the dollar.

The exchange rate is not just a measure of the economy’s health, but also has a direct impact on every aspect of the economy – ex-ports, imports, interest rates, inflation, and even domestic companies. Therefore, the question of where the Rupee is headed is an important one, even as it is a difficult one to address. CFO Connect talked to two experts on the subject – Haresh Desai, Director, AV Rajwade and Company and Professor Govinda Rao, Director, National Institute of Public Finance and Policy – to understand the forces at work and how they are likely to develop in the near and medium term.

how did we reach here? From 2002 to 2007, the Rupee steadily

appreciated as the dollar fell against major world currencies in this period. The sudden appreciation of the Rupee over this period was a result of the RBI’s desire to keep infla-tion under control. The Rupee went up to the level of Rs 39.75 per dollar and talk of 35 or even 30 levels was increasingly common and even somewhat credible. Around last July it was hovering around 44 to the dollar. Then over the last year, it fell to 52 to a dollar, which was roughly a 30 per cent fall, which is even steeper over the past six months at 25 per cent. The reason for the fall was that the Rupee was overvalued in 2010-11 compared with its real effective exchange rate (REER). Why was this so?

Though India’s current account deficit is larger now, in both absolute and in relative terms, than it was in 2010-11, it was easier to fund it through equity flows as FII money was flowing in. Net equity flows were to the tune of USD 40 billion in 2010 and they kept the Rupee stable. In 2011, equity flows dried up, but were quickly replaced by debt. The conditions were right – dollar interest rates were falling as developed countries tried to jump start their economies by keeping interest rates low. Meanwhile, the RBI was trying to cool the over heat-

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A fall in the value of a currency tends to balance the current account deficit by making imports dearer so demand contracts making exports more competitive…this is now happening

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ing economy by increasing interest rates. For Indian corporates, it made sense to borrow in dollars and since interest rates were moving in predictable directions, a large part of the borrowing was not even hedged, thus saving the borrowers forward premia! This inward flow of dollars kept the Rupee more or less stable through August 2011.

At that point, S&P’s downgraded US debt, and strangely, rather than falling, the dollar rose. The market believed that the consequent worsening of the global economy will affect developing markets more and hence, retreated to the safety of the dollar as the world’s reserve currency. This led to a drying up of debt and with equity flows already down, for-eign inflows to India plummeted. At the same time, the REER dictated that the Rupee was overvalued and its optimal level should be 52 or thereabouts. The RBI was comfortable to let the Rupee find this level. But, as often happens, the Rupee overshot this mark and fell to as low as Rs 57. This forced the RBI to intervene and introduce measures to prop up the Rupee as by now, it believed that speculators were hammering the currency.

not all badClearly, a falling currency makes imports expen-

sive and therefore leads to inflation. For a country like India, which needs imported oil to fuel its eco-nomic growth, this is not good news. Worse, since political compulsions do not permit passing on the rise in the landed cost of oil, it worsens the deficit,

whether it is on the books of the government or the public sector oil companies. However, a falling cur-rency is not all bad. In fact, an over-valued currency can wreak havoc with a country’s exports and even domestic producers. The latter suffer because they are not able to compete with cheaper imports. A fair valued currency therefore, benefits both. Also, a fall in the value of a currency tends to balance the current account deficit by making imports dearer (and therefore, making demand contract) and exports more competitive. There is some evidence that this is now happening. Gold import fell in the last quarter of the previous fiscal due to higher landed cost. Given the high and perhaps irrational value that Indians attach to gold, it is surprising but reassuring that the laws of economics work for this commodity as well! Higher oil prices have not led to demand moderation because the higher cost has not been passed on to consumers. This is clearly bad economics.

The impact on domestic businesses can be quite dramatic. Many industries make a choice between imported and domestic equivalent products based on price. As a currency depreciates, it becomes cheaper to buy domestic products. In fact, com-panies that consume commodities, such as paper and chemicals are already shifting to local variants. Also, some companies price their goods at par with the landed price of imports. They will therefore, be able to enjoy higher margins. This could have a big impact on the topline of many companies. However, it can take up to a year after the currency begins depreciating for these phenomena to fully play out.

Limited muscle to prop up the RupeeThough India has amassed large foreign ex-

change reserves by historical standards, a closer examination shows that it is not enough to prop up the Rupee if it comes under severe hammering. India’s reserves amount to approximately USD 285 billion, a level that seems to be healthy. However, India’s imports in 2011-12 were USD 488 billion. Therefore, our foreign exchange reserves are only slightly more than six months worth of imports, a level that is considered desirable. This leaves only about USD 40 billion in the RBI’s kitty to fund the gap between current account deficit (about USD 5 billion a month) and capital inflows (about USD 2-3 billion a month). At about USD 2-3 billion a month, the current level of reserves can last nearly 18 months, a period over which the current account deficit should reduce and, or capital inflows can increase. However, the reserves are not adequate if there are strong negative triggers that lead to a sudden or increased flight of capital. Although the prospect of Greece’s immediate exit has been avoided, the risks to the Euro zone remain and a

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coVeR sTorYsudden escalation in risk will make it difficult for the RBI to continue its intervention. This is why it remains cautious about supporting the Rupee and intervenes only when very necessary.

Solving the wrong problemIn response to the sense of panic when the Rupee

breached the Rs 57 mark, the RBI announced mea-sures to stem the slide. This was also the last day in office for Pranab Mukherjee as Finance Minister and there were expectations of bold measures on the policy front also. However, the steps announced amounted to little more than short term efforts to attract dollars to solve the immediate crisis. These were: • The RBI raised the foreign investment ceiling on

government bonds by USD 5 billion to USD 20 billion;

• It permitted companies with foreign earnings to borrow overseas to repay Rupee loans with a USD 10 billion cap;

• It also allowed sovereign and pension funds to buy state bonds; and

• It lowered the minimum holding and maturity period for foreign portfolio investments in the Infrastructure Development Fund.However, the markets were not impressed. C

Rangarajan, an influential advisor to the govern-ment said that other measures could follow, such as raising non-resident Indian bonds and financing of oil imports through bonds. Separately, a news report in a business daily hinted that the RBI was also considering measures to prevent banks from selling gold coins. Banks were permitted to sell gold coins a few years ago, when India had the opposite problem – too much inflow of foreign exchange. It is hard to say how much inflow these measures will generate in the current economic environment. However, one can argue that this is band-aid treatment, and can even have undesirable long term consequences.

All the above measures seek to bring short term capital into India. Some analysts argue that it is India’s reliance on short term capital that has made the country vulnerable to such shocks in the first place. Though an inflow at this stage is welcome, it will come with long term costs. It is likely that capital that comes at this time of global uncertainty will be speculative in nature and could flow out just as easily if risks increase either within India or globally. This argument assumes that there is good capital (long term) and bad capital (short term).

Solving the right problem

Increase price of oil-based fuelsOil sector deregulation has been talked of for

more than 15 years, and several roadmaps have

been drawn up and abandoned. The govern-ment’s inability to deregulate prices of petroleum products, especially diesel and kerosene, has led to massive under-recoveries for the public sector oil companies, which the government treats as its own departments, even though they are publicly listed. It has also led to the still-birth of private sector oil marketing ventures. Highways in India are peppered with abandoned petrol pumps of private companies which made the investment in the hope that the roadmaps for deregulation will be adhered to.

Recently, the government has deregulated the price of motor spirit (petrol). Though in theory it is fully deregulated, in reality prices are always more difficult to increase than to reduce, in response to changes in global markets. In any event, this is not adequate. The real culprits are diesel, cooking gas and kerosene, which remain firmly controlled

Some analysts argue that it is India’s reliance on short term capital that has made the country vulnerable to such shocks in the first place

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by the government for fear that any increase will lead to public anger and provide the opposition a stick to beat it with. It already suffers from both on various other matters.

However, apart from burning a hole in the books of public sector oil companies and making them incapable of investing in future capacities, this strategy also leads to a higher fiscal deficit. Worse, it fails to transmit the signal to consumers to curtail their consumption in response to higher cost of production.

The Government must bite the bullet and increase the prices of diesel, even if it is in small but frequent increments. It should also try to use technology, such as direct cash transfers, to curb pilferage and unintended beneficiaries. True, there will be anger among people already suffering from high inflation, but if this is not done, the economy will not be on sound footing when elections take place in 2014. The Government may realise that deregulating petroleum prices or at least partially doing so (for example by capping the maximum subsidy per unit of fuel) has electoral logic as well as economic.

Improve investor sentiment Investor sentiment does not improve by deny-

ing the problem or shooting the messenger. Each time India’s economic and political environment is criticised, or India’s rating reduced, it results in an-gry reprisals by the government. This may be good

for soothing the nerves of laymen worried about their investment, but does nothing to assuage the underlying concerns of serious investors in India. Accepting that the country has a problem and that it stems from the political gridlock is the first step and an important signal that the government is seized of the matter. This will also put pressure on allies and foes to soften their opposition to necessary reforms. That sentiment matters a lot became evident on July 29, when the Rupee made its biggest single-day gain in three years in response to some reassuring comments by the Prime Minister, who has taken over the role of Finance Minister after Mr Mukher-jee’s exit to focus on his Presidential campaign. Of course, which way the Rupee goes from here will depend on whether there is consistency of actions over the coming weeks and months.

The other important thing to do will be to increase the pace of execution of projects on the ground. Announcing new initiatives will not help until investors have doubts about the ability of the government to implement its policies. Several projects of national importance have been stuck in red tape and official apathy. The Mumbai-Delhi Corridor is an example. It could catalyse develop-ment in large parts of the country but has not made substantive progress in over four years.

The power sector is suffering from chronic short-age of fuel – coal or gas – and several projects, in which billions of dollars have been invested, are not able to generate power. The shortages, already se-vere are biting even harder now, as power outages are increasingly longer and more widespread. Solv-ing turf issues between ministries and making sure that projects that are close to completion are given all the support they need, is the need of the hour.

Similarly, telecom, one of India’s success stories has been mauled by bad policies and administra-tive action. The Supreme Court ruling cancelling licences of 122 licencees has not helped India’s im-age as an investment destination. The response of the government to the mess has only created more of it. It needs to create simple and transparent rules with the objective of further increasing the penetra-tion and usage, especially of data services, such as mobile money, education, health and eGovernance.

Capital of the right kind is waiting to come, but enabling conditions need to be created first. Ikea, a retail giant, known internationally for its clean business practices, has announced its willingness to invest over USD 2 billion in India, provided the conditions for single brand retail FDI are made more reasonable. Drafted under pressure from political parties and other groups, the current con-ditions for retail FDI investors are far too stringent and unfavourable for serious investors. This is an opportunity to set policies right and invite not just Ikea, but other large retailers who would like a slice

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coVeR sTorYof India’s growing consumer market pie. That the country has potential is evident from Coke’s recent announcement to invest USD 5 billion over the next few years in India.

In aviation, India has adopted a strange policy of not permitting foreign airlines which have the expertise, desire and money, to acquire stakes in the Indian aviation sector. That this sector badly needs investment is evident from the fact that several leading airlines are bleeding profusely and could go under if capital is not infused in time. Removing this limitation will bring much needed capital into this important sector and also help bridge India’s current account deficit. Insurance is another sector in crying need of capital and expertise. Relaxing regulations will not only benefit shareholders of insurance companies, but also increase the penetra-tion of insurance services in the country. Why hold such important social benefits hostage to fears of political backlash?

Creating a stable and predictable tax regime is important to bring in foreign investment. Clearly, India has no reason to become a tax haven but regulations must still be drafted in a manner that appear just even if firm. It is said that investors do not mind higher taxes, but baulk at uncertainty in the tax regime. Handling the Vodafone tax issue with sensitivity and fairness will ensure that the frayed nerves of investors are soothed. Even the prospect of doing so saw the Rupee make its single biggest gain in a day, in three years, on June 29.

So, where is the Rupee headed?A recent survey of bank treasurers and econo-

mists showed that most expect the Rupee to fall past 58 and many expect it to go to as low as 60 to the dollar in the short term. A CFO that we spoke to said it could go down to 65 by Diwali. The above mentioned survey was done just after the week when the currency fell by 3 per cent, so there may have been some rub-off from recent performance. However, most of them felt that in the medium term, it could bounce back a little as the govern-ment’s hand is forced on some policy measures and global uncertainty reduces.

Mr Desai believes that volatility is set to con-tinue for a few more months and hesitates to predict a specific level. It is likely, however, that Rupee will fall further in the short term because of higher risk perceptions stemming from Europe and policy inaction by the government.

Though he is uncertain about the short term, he is reasonably confident that by March 2013, the Rupee could be in the 52-54 range. This is because there will be a reduction in the current account deficit partly on account of the depreciation itself and also because of a fall in the prices of com-modities in the global markets. Oil has been below

USD 100 per barrel for some time and even other commodities are trending down. This is the com-bined effect of the slowdown in Europe and more recently, China. This is a positive development for India as oil is the single largest item in its import basket and a fall in its price will have a significant impact on the current account deficit, though the

This is going to be the decade of 50s (that is, the Rupee will move between 50 and 60 to the dollar)…all stakeholders will need to adjust to this new normal

effect will be more visible in about six months time as contracts already made at higher prices mature. If the government could use this opportunity to partly decontrol diesel and cooking fuel prices, then a sustainable foundation for current account management may have been put in place.

Mr Desai believes that with the Rupee strength-ening to a level of the low 50s, the RBI may want to buy dollars again to augment its reserves. One of the key realisations of the recent fall in the Rupee has been that sub-400 billion dollar reserves do not provide enough protection. He asserts that this is going to be the decade of 50s (that is, the Rupee will move between 50 and 60 to the dollar), and the era of sub-50 is firmly behind us. All the stakeholders will need to adjust to this new normal.

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