Indian Rupee Depreciation - A crisis that was waiting to happen

The context

The Indian Rupee (INR) has depreciated by c.30% against the dollar (USD) over the past six months and it’s not clear if it has already bottomed out. What is really worrisome for global policymakers and businesses alike is that a large portion of the emerging market seems to be affected by this currency crisis. Morgan Stanley has labelled the currencies of India, Brazil, Indonesia, Turkey and South Africa as ‘The Fragile Five.’

At a juncture in global growth story where emerging markets including BRICS were to play a significant role, this development has certainly spooked the markets.

The trigger behind the implosion

Macroeconomic imbalances build up over a long term and are visible most of the time, but myopic politico-economic issues generally lead to these being condoned. Due to the practical difficulty of being able to diagnose the exact tipping point – when the imbalance would explode and what the trigger would be – most decision makers like to think and wish that it would not be now.

The current, ongoing depreciation of the Indian Rupee (and other emerging market currencies) is one such explosion that was waiting to happen and just needed a trigger.

India suffers from high twin deficits (internal – fiscal deficit, external – current account deficit) and high inflation. This precarious position got exposed on account of a number of recent developments emanating mainly in the US. These include an improved US economy, the decision of the Fed to gradually end Quantitative Easing (QE), and possible war in Syria. All these developments have driven global money towards the Greenback making it much stronger and the other currencies much weaker. The figure above shows our currency’s vulnerability. Each time external factors lead to an exodus of FII (Foreign Institutional Investors) the fragile currency generally goes for a dip.

Where does this lead the economy to?

After the first round of currency depreciation this fiscal (May-June), the economy was perceived to have stabilised at the new exchange rate.

Despite the ongoing political paralysis, and impending elections the economy was forecasted to do better than the previous year’s 5% GDP growth. The heady days of greater than 8% GDP growth were nowhere near but at 5.5-5.7% in 2013 and 6-6.5% in 2014 the economy was looking relatively better.

In this scenario, where does the current round of currency depreciation that began in August 2013 lead the economy to?

India is not an export oriented economy so as to benefit from such depreciation. Instead it will be faced with imported inflation and high borrowing costs both of which will hurt the domestic purchasing power. This in turn will slowdown consumer spending as well as investment. While fiscal spend may go up owing to the trend observed before elections, the rating agencies would ensure that would not be easy. Monetary policy, which remained tight under Governor Subbarao in order to check inflation, will have to most likely remain so under the new Governor Rajan to provide some pull to the capital markets.

As far as the fall of the INR is concerned, a regime change, or a revised policy stance will not bring back its value immediately. Other attempts such as controlling import of luxury items or purchase of dollars by Oil Companies from RBI to skip the spot market are temporary and can last for only so long.

There is no quick fix to the current situation, and only long term efforts aimed at reducing supply bottlenecks that bring down inflation in a high-demand economy, exploring ways to reduce exposure to oil price fluctuations that hurt our current account position, a more rational deployment of public funds to check our fiscal deficits and resolving the policy paralysis are the only meaningful ways to reduce instability.

Under such circumstances it would not be surprising to expect a further downgrade of the growth forecast. In fact, BNP Paribas has already trimmed the growth to 3.7% for this fiscal. The only upside to this forecast can be a good harvest on account of sufficient monsoon this year.