Volatility is the new normal

The depreciation of the rupee in the last two weeks has again highlighted the structural deficiencies in the Indian economy and continued dependence on capital account flows to finance the balance of payments. While one can argue that the recent depreciation was driven by broader global concerns — US Federal Reserve tapering off its quantitative easing (QE) programme and the associated rout in emerging markets globally, it is time we step back and ponder the reasons behind current developments and the macroeconomic issues that will continue to influence the rupee.

The rupee’s level over the past year has reflected the constantly changing balance of opposing forces in the economy — a large current account deficit ($90 billion, 2012-13) and elevated commodity prices kept it under pressure through 2012. This changed in 2013 when strong foreign flows into debt and equity ($17.3 billion) supported the currency and kept it in a broad 53 to 55 range. This has changed in recent weeks when sizable foreign institutional investor outflows were witnessed (circa. $2.8 billion from May 21 to June 10) driven by liquidation of bond positions. The result is the extreme volatility and depreciation in the rupee we are seeing currently.

The Reserve Bank of India’s intervention in such scenarios can only be viewed as an attempt to soothe sentiment and keep speculative activity at bay. It is unlikely to fix the core structural issues that need to be addressed, such as:

— Narrowing the current account deficit (CAD). Even though CAD is expected to drop from $90 billion (4.9 per cent of the gross domestic product) in FY 2012-2013 to $80 billion (3.9 per cent of GDP) in FY 2013-2014, 44 per cent of the country’s imports shall still be driven by crude/energy products and gold, which we cannot wish away despite recent policy measures to curb gold imports. To further narrow the CAD, policymaking needs to foster an export-led revolution in the real economy by channelling investments suitably, replicating our success in the information technology industry.

— Financing the CAD sustainably by attracting sticky foreign investments. This will need to be driven by lowering transaction costs, simplifying access to Indian markets and having a fair and unambiguous tax regime. In this context, recommendations of the Chandrasekhar committee on easing rules for foreign investors in Indian capital markets are a step in the right direction.

— Improving the investment climate and ensuring policy changes lead to actual flow of funds in a reasonable timeframe. Changes in foreign direct investment and other policies can lead to real investment only if backed by fast track clearances, stability (and clarity) in the tax regime and effective labour and land acquisition laws.

— Ensuring India’s sovereign rating at least remains stable by continuing to focus on the stated fiscal deficit goals and other macroeconomic parameters.

The risk management function in corporate India has been a challenging place in the last two years. This is especially true for businesses with large international trade exposures and foreign currency debt. While recent moves may look exaggerated viz. real effective exchange rate levels, one cannot afford to downplay the potential impact of developed economies tapering their QE programmes and the implications for India in terms of foreign currency flows.

In this environment, we should expect episodes of volatility and uncertainty in the currency to continue to surface in the medium term, at least till structural economic issues are addressed adequately. Corporate India will need to accept the current currency ranges and higher volatility as the new normal and ensure their treasuries are governed by clearly defined risk management policies that provide flexibility around the hedging horizon, hedge ratios and product selection.

The author is Managing Director, Head of Asia Pacific Risk Solutions Group, Barclays