Address Basics to Stem Rupee Slide

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Publication: The Economic Times Delhi; Date:2011 Dec 26; Section:Viewpoint; Page
Number 15

Address Basics to Stem Rupee

Slide
RASHESH SHAH

The recent depreciation of the rupee to historic levels has created a nearpanic 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.

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Address Basics to Stem Rupee Slide

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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)

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