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Tue, Jul 16 2013. 08 24 PM IST

If growth differentials continue to stay narrow and inflation

differentials continue to stay wide, this wil l not be the las t

time we bemoan the sudden fall of the rupee. Photo: Mint

Rupee: the $25 billion questionRigid current accounts and sudden stops of capital never allow for easy policy choices

The Reserve Bank of India (RBI) has s et the cat among the pigeonsby signalling that it is getting ready to mount an interest rate defence

by tightening liqu idity conditions. Markets appears shocked, analysts

are getting trigger-happy to downgrade their growth forecasts and

there appears to be a sense of (irrational) bewilderment at the latest

move.

But Monday nights move should not come as a real surpris e when

one considers the damage that a sharp rupee depreciation can

unleash, the funding gap that exists on the balance of payments, the

speculation that is riding on this funding gap, and therefore the

outlook for the currency in the absence of any action. Indonesia and

Brazil have already raised rates over the last week, and Turkey

appears to be on the verge of doing so.

But to fully appreciate why policymakers had little choice but to go down this road, its important to better appreciate the outlook for the

rupee. Suffice to say, the rupee is not the only currency to have depreciatedall emerging market (EM) currencies have tumbled as part of a

re-pricing of risk as the US Fed gets set to slow as set purchases . But the rupee is the second-worst performing EM currency. And while the

trigger may not have been India-specific, the consequences certainly will be. An 11% depreciation in eight weeks is bound to be dis orderly

expected to push up wholesale-price inflation by 80-100 basis points (bps), stress unhedged corporate balance sheets and increase the

fuel subs idy bill by 0.3% of gross domestic product (GDP).

This much is known. The burning ques tion is whether the bleeding is over. Is there more to come? Or has the move been overdone? Is the

rupee stuck in a self-fulfilling spiral? Or are these fundamental imbalances playing out?

Is this fair?

Answering this will inevitably involve an assess ment of the rupees fair value. While there are different approaches to es timating an

equilibrium exchange rate, ultimately what matters is a countrys growth (productivity) and inflation differentials vis--vis its trading partners.

History has s hown that countries that have high growth differentials vis--vis their trading partners experience a real appreciation of their

currencies. That real appreciation can be mani fested either through higher inflation or an appreciation of the nominal exchange rate.

Therefore, the higher the inflation differential, the lower wil l be the nominal appreciation (or the greater will be the depreciation!)

In sum , countries that have relatively high growth differentials and relatively low inflation differentials vis--vis the rest of the world (India in

the mid-2000s) should experience trend nominal appreciation. If the opposite is true (India over the last two years), the sus tained bias on

the nominal exchange rate is to depreciate.

Yet, assessments of fair value are medium-term concepts, and the currency can deviate from its equilibrium for months on end. On a more

imm ediate basis , balance of payments (BoP) fundamentals will drive the rupee. The question, therefore, is in the current environmentin

which the rupee has already depreciated by 11%, gold imports have seem ingly abated for the moment, US treasuries have surged by 100

bps and the Fed tapering is expected soonwhat will Indias BoP look like this year?

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Bloated and inelastic

To answer this, we first need to have a view on Indias expected current account deficit (CAD). One of the presumed benefits of a floating

exchange rate is that it will help equilibrate external imbalances . Rupee depreciation should be welcomed under certain circumstances,

because i t should boost exports (by making them cheaper), curtail im ports (by making them m ore expensive) and thereby narrow the trade

and current account deficit.

Unfortunately, this hypothesis has not played out in India. Between 2010 and 2011, the rupee depreciated almost 5%, yet the CAD surged

from $46 billion to $78 billion. Part of this was undoubtedly rising commodity prices but there were several disturbing India-specific factors

(discussed below). Last years case is even more damning. The rupee depreciated almost 12%, crude prices actually fell, and gold imports

moderated in value terms . Yet, CAD increased further by $10 billion to $88 bill ion.

Whats going on? Why is CAD not more res ponsive to sharp currency movements? The problem is twofold. On the export side, our

merchandise exports have become increasingly price inelas tic. Exports rise when global growth pick-up but dont respond meaningfully to

depreciation of the real exchange rate. Despite the 12% rupee depreciation last year, exports actually contracted as global growth fell off.

More generally, the lack of manufacturing productivity and competitiveness has meant that exports have not been able to exploit nominal

and real currency depreciation in recent years.

But this is only half the story. Worryingly, policy and regulatory logjams have resul ted in several rigidities on the import s ide. Coal imports

have more than doubled over the last five years, iron ore exports have fallen off from $6 billion to virtually zero, scrap metals imports have

doubled and fertilizer imports have risen 33% over the last three years. The deficit on these fronts rose from $22 billion to $38 billion

between 2010-11 and 2011-12driving 50% of CAD increase during that year. More worryingly, on some of these fronts, things are likely to

get worse before they get better.

Given this, a lot of hope is being pinned on gold imports after they fell sharply in June. But lets not count our chickens before they hatch.

Gold imports are weak every single Juneas nobody buys gold during the mons oon. The real test of whether gold demand has abated will

be in September.

Yet, even assum ing that gold imports fall by 20% over the las t year, the Indian oil basket averages $105 and exports actually turn around,

the FY14 CAD is expected to stay at a bloated $85 billion.

A $25 billion funding gap

The question, therefore, is whether this can be funded in the current environment?

To answer this , we need to separate the more stable sources of funding (FDI, ECBs, trade credits, NRI deposits) from the more volatile

risk-on, risk-off flows such as portfolio debt and equity flows. Worryingly, over the las t three years, the more s table source of funding have

only averaged $50 bil lion. To be sure, they rose to $62 billion last year as trade credits rose on the back of lending normalizing in the euro

area.

Prima facie, attracting even las t years quantum wil l not be trivial. Foreign direct investment (FDI) flows could potentially rise if the

government were to increase sectoral caps but it is hard to see them surging given the weak investment climate and the looming election

cycle. Furthermore, external comm ercial borrowings (ECBs) will be far more expensive given ris ing treasury yields and credit spreads .

Offsetting that, perhaps, NRI depos its could get a boos t from the weaker rupee. But, all told, India will do well to attract another $60-62

billion from these stable sources.

But this still leaves us dependent on a fresh $20-25 bill ion of portfolio inflows, even ass uming there are no further outflows. Can that be

achieved in a world marked by debt outflows in EM markets, US treasury yields at a two-year high, concerns about the stability of the rupee,no discernible s igns of a growth pick-up in India, and a general election months away? Net portfolio flows for the first quarter of the fiscal

year were essentially zero. So attracting $20-25 bill ion in the remaining three quarters will tough by any stretch of the imagination.

Something has to give

And that is the bottom line. That we have been relying on $20-25 bil lion of volatile portfolio flows to finance a bloated and rigid CAD in a

world fuelled by monetary accommodation. At som e point, the party had to end and these volatile flows would s top or reverse. And a $25

billion gaping hole in the BoP would emerge.

So how do we bridge this gap? There are only three alternatives. The first is to hope to fill the gap through other sources of funding (e.g.

sovereign bonds). But to raise anything close to this quantum in the current global environment of rising interest rates and a marked

distaste for EM assets appears very challenging.

The second option is for RBI to intervene aggressively in the forex market to bridge this gap and avoid more depreciation. But is the central

bank prepared to intervene to the tune of $20-25 billion? Should it be spending 10% of the reserves to finance one years CAD?

The theoretical case for intervention rests on either the real effective exchange rate (REER) being significantly undervalued or the

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macroeconomic consequences from sharp depreciation being very severe. With Indias growth differentials narrowing and inflation

differentials high, its hard to make a convincing case for the former. The case for destabilizing macro consequences is strongerthe

depreciation is likely to fuel more inflation and play havoc with public and private balance sheets. But even so, should RBI be filling a $25

billion gap? After all, reserves have been accumulated through capital flowsas opposed to current account surplusesand so there are

corresponding liabil ities in the economy.

A case can be made that if the time that this intervention buys is used to address the structural imbalances in CAD. However, if there is li ttle

adjustment on CAD, and the global backdrop does not change, expending a s izeable fraction of reserves would make the economy even

more vulnerable to BoP pressures later.

There is a third way to bridge the gap: by further tightening fiscal and monetary policy to squeeze growth and thereby choke the current

account deficit. In markets where fixed income flows are m aterial, raising rates also makes local currency debt ass ets more attractive. This

is the class ic interest rate defence, and one practised by Indonesia and Brazil over the last 96 hours. And that is one RBI has (correctly)

chosen to go down through its m easures on Monday night. But will i t hold its nerve even if there is collateral damage to growth in the

process? Will this be politically acceptable in an election year?

None of these options appear very palatable. And that explains the rupees problem. That, without any of these options being taken to their

logical conclus ion, the exchange rate would need to bear the brunt of the adjustment. No wonder then that no level of the rupee appears

sacrosanct any more. Because, given the low price elas ticity of Indias current account deficit, nobody is quite sure of the extent the rupee

will need to weaken to bridge a $25 bi llion gap. And given this lack of anchor, the climate is ripe for self-fulfilling spirals .

Rigid current accounts, reliance on volatile capital flows, and sudden s tops of capital never offer easy choices for policymakers. And therein

lies the rupees near-term problem.

And in the medium term , if growth differentials continue to stay narrow and inflation differentials continue to stay wide, this will not be the

last time we bemoan the sudden fall of the rupee.

Sajjid Chinoy is senior South Asia economist at JP Morgan. Comments are welcome at theirview@livemint.com