Condemned to repeat the past

Local and external factors are coming together to trigger another outsized depreciation of the rupee

Rajeev Malik

Let me begin by asking a simple - but relevant - question: can policy makers in a country commit the same mistake twice within two years? At first blush, one would think not. After all, people often learn from their mistakes. Even when mistakes are repeated, they are hardly in quick succession. But India's policy makers are working hard to make history by repeating the same oversight that has already knocked the stuffing out of the rupee.

No other Asian country comes close to India in having misdiagnosed its economic problems, committed egregious policy boo-boos, preferred band-aids instead of lasting cures, and treated symptoms rather than the underlying disease. The good news is that under the threat of a downgrade by sovereign credit rating agencies and the political implications of the subsequent economic fallout, the government finally began undertaking some corrective actions. Though welcome, these actions at best constitute a whimper of a response to the mammoth economic challenges facing India. The bad news is that the misdiagnosis continues in some key areas - exchange rate management remains a worrying example.

A country's exchange rate is a dynamic relative price of one currency in terms of another. It is affected by cyclical and structural cross-currents, and has local and external drivers. Emerging economies often target the visible nominal bilateral exchange rate, say, rupees per US dollar, or the trade-weighted exchange rate. But economic history is replete with examples of currency crises in emerging markets because of misaligned exchange rates.

Interestingly, none of the governments where the currency took a beating acknowledged initially that their exchange rates were overvalued. In fact, delay in such an acknowledgement and subsequent corrective action were key factors that precipitated a more dislocating currency adjustment. More often than not, the delay is because of conflicting economic and political goals and the lack of appropriate medicine because it is politically undesirable.

All of the above is relevant to India. The Reserve Bank of India (RBI) will deny it, but its effective rupee management underwent a sea change after the global financial crisis. Gone was the prior aggressive intervention in the currency market to check the pressure on the rupee to appreciate because of destabilising capital inflows. The new mantra was a hands-off policy. This had its merits given the constraint: tight monetary policy, to check inflation. But along the way Indian policy makers forgot whether or not the rupee was misaligned. Capital inflows were financing the wider current account deficit and hence it was thought that the rupee was appropriately aligned. But the need to offset the high inflation differential of India with its trading partners was ignored. Thus, the rupee became overvalued and needed significant depreciation beginning 2011 to correct its misalignment.

Unfortunately, even today Indian policy makers' approach towards the rupee remains inconsistent. The RBI is continuing with its hands-off policy towards the currency, but the government keeps opening up new avenues to attract capital inflows to finance the record-high current account deficit, thereby preventing the rupee from undergoing its much-needed depreciation. Apart from making the economy consciously more vulnerable to volatile risk-driven capital inflows, this approach gives a false sense of security, that the nominal exchange rate is stable. However, it misses the crucial point about the need for rupee weakness, given India's high inflation differential with its trading partners and the multiple setbacks to the competitive landscape for Indian business.

Don't forget that reported inflation is understated, with the RBI estimating that wholesale price index (WPI) inflation would be higher by around four percentage points if some long-overdue administrative price increases were to be announced. In any case, the more relevant consumer price inflation is well above WPI inflation. Finally, populist policies in the last few years have pushed up the economy's cost structure without any comparable increase in productivity.

A weaker rupee and structural reforms in the real economy are needed to boost India's competitiveness. Unless there is a dramatic decline in consumer price inflation and/or productivity-enhancing structural reforms, the rupee is poised to return to its pre-2002 trend of annual depreciation. The government's misguided approach towards the rupee is only kicking the proverbial can down the road.

Given current thinking, New Delhi will probably resort to more measures to attract portfolio inflows. This could be positive for the rupee in the very near term. But rupee rallies should be sold into. Indeed, with financial markets likely to be increasingly focused on a less favourable global liquidity, countries with unsustainably high current account deficits will be vulnerable. Frankly, India is not in a position like, say, Singapore, to actively use its exchange rate to check imported inflation. Avoiding rupee depreciation is not the answer to our fiscal mess. Indeed, a weaker rupee should be thought of as part of the solution, not part of the problem. Gradual rupee depreciation will minimise the translation impact of imported prices on domestic prices. Additionally, the current weak domestic demand conditions will soften the second-round impact.

Several comments by government officials carry a celebratory tone when they note that the wide current account deficit has been adequately financed by capital inflows. This, of course, is partly because of their own actions to attract more capital inflows. Consequently, there has been no erosion in the stock of foreign reserves. But the fact of the matter is that, consciously or unconsciously, the government is targeting a narrow range of nominal rupee-dollar exchange rate, even though the RBI is not officially doing so.

It is a pity that we have learnt nothing from the currency flu that hit the rupee in 2011. Currency management is more than just ensuring adequate capital inflows to finance the current account deficit. Recall that prior to 2002, the rupee used to depreciate annually against the US dollar despite the current account deficit being more or less financed by capital inflows.

External and domestic factors make the rupee perhaps the most vulnerable Asian currency. It is poised to weaken despite some improvement in the current account deficit in 2013-14, in my humble opinion. India's current rupee management, the lack of real sector reforms, the anticipated US dollar appreciation, the coming growth uplift for cyclical Asia in 2014, and the slowdown in capital inflows that will likely more than offset the decline in the current account deficit point to a high possibility of 10-15 per cent depreciation in the next 12-15 months. Additional pressure on the rupee to weaken will come from the impact of the ongoing depreciation of the Japanese yen on other Asian currencies. Sell into rupee rallies as we are condemned to repeat the past.

The writer is senior economist at CLSA, Singapore.
These views are personal
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of or the Business Standard newspaper

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First Published: Apr 10 2013 | 12:50 AM IST

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