Sunday, August 25, 2013

Does falling rupee point to economic mismanagement?

There is renewed talk of a 1991-like crisis following the steep fall in the rupee in recent days. It's good that Kaushik Basu of the World Bank has joined D Subbarao and others in quashing such speculation, much of it coming from ill-informed corporate chieftains.

Many points have been made by way of dispelling such talk- notably, the fact that forex reserves are now worth 7 months imports (instead of a couple of weeks in 1991), India's low external debt, a vastly improved private sector. But, perhaps, the most compelling point to make is that one of the root causes of the 1991 crisis, a fixed exchange rate, is now missing. A floating rate is an automatic adjustment mechanism in the face of a widening current account deficit. When the current account deficit widens, the currency depreciates; exports should go up, imports should go down (although how much depends on elasticities of exports and imports) and the deficit gets bridged as a result.

This self-correcting process can come unstuck for two reasons: one, inflation rises as a result of depreication and renders domestic goods uncompetitive; two, as the current account deficit widens and inflation rises, foreigners lose confidence in the economy and decide to fee, so it becomes difficult to finance the current account deficit. This could cause the currency to go into free fall. Now, let's apply these principles to the current Indian situation.

It should be clear that it's okay if the rupee depreciates as long as there is orderly depreciation. How much should the rupee depreciate? Here, it's useful to go by the real effective exchange rate (reer). This is the exchange rate after factoring in inflation rate differentials between a given country and its trading partners. The reer of the rupee, weighted by trade with respect to 36 currencies, had depreciated by just 3% in June over the previous year. Over 2005-13, the depreciation was 6%. These are both well within the RBI's comfort zone of an annual variation of reer of 5%. If we factor in weak global trade, then certainly a case existed for a fall in the rupee before the recent decline to Rs 65 (and bounce-back to 63).

A second reason for rupee depreciation is that the Fed is poised to taper off quantitative easing. This will mean a reversal of the flows that came in flooding post the 2007 financial crisis. All emerging market currencies are getting beaten as a result; India is no exception.

Thirdly, as the RBI has indicated in its latest annual report, there is evidence that some of the decline in the rupee is on account of speculative trades- non-deliverable forwards (NDF)- being carried out by MNC banks in the overseas markets. They seem to have been selling short overseas and buying forward here.

Which part of the above can be said to constitute economic mismanagement? The current account deficit has grown wider for a number of reasons. Slowing global trade (no fault of the government); a fall in mineral exports because of a Supreme Court ban on mining in certain places (not much the government can do in the short-run); an increase in coal imports (partly because Coal India cannot expand mining because of environmental and forest area issues); and an increase in gold imports, thanks partly to sustained high inflation. Now, you could blame the government for some of the inflation because it did not contain the fiscal deficit in time. But much of the inflation is food-driven and there is not much the government can do about this either in the short-run (especially in so far as it relates to non-cereal food items).

In short, the government-bashing and talk of 'policy paralysis' we have seen are, in my view, overdone. Certainly, the government needs to do what it can to expedite clearances and see projects through to completion. But issues such as environmental clearance and land acquisition involve questions of trade-off between growth and equity that cannot be resolved in a hurry.

What does the new RBI governor need to do in this messy situation? The RBI must reverse the moves to tighten liquidity in recent weeks (some of this has just happened) and then try to ease interest rates. Further fiscal austerity must be avoided. A focus on fiscal and monetary policy to support growth plus Re depreciation plus a gradual revival in economic growth is what we must bank on.

More in my article in the Hindu, A new note on Mint Street.


Anonymous said...

The rupee is depreciating, the GDP numbers are falling, IIP numbers are plunging, food inflation is rising,'stagflation' has likely creeped in, retrospective tax judgments are issued, Company's Bill is hold since years in Parliament, coal reforms are stagnated, markets are down, corruption is high, FDI's are on hold, judiciary is functioning as usual, there is not predictability of govt in its plans & budgets - and we say its all due to global factors; nothing govt can do.

And for a moment, if it wast to be agreed, at least the govt can signal an alarm in its budgets & policies that coming few months the GDP will fall & currency rates with surge etc etc. Be bold and transparent to public saying 'Because of X,Y,Z reasons we feel 2013-14 would not be a good year'...instead of making political statements at the hindsights...

Economics is a game of numbers and can be moulded & twisted the way you want to interpret. The fact of matter is - a poor residing on street cannot have onion in his plate today and foreign investors are highly skeptical about growth story that our leaders were rhetoric about few years ago.

Is our economy so fragile to such global factors - and if they are indeed beyond control - why are only we impacted so much and not other emerging economies?

Robustness of economy is turning towards fragility. And not just on economic front, but on all scoio-political-economic fronts. That's the concern.

Anonymous said...

'Its all due to global factors; no fault of govt' - I think this statement should be made more to foreign media & investors and not Indian markets or Indian media.

Ruminating Optimist said...

But isn't food inflation one of the reasons for the overall high inflation? What about onions? The big mismatch in the fall in production and rise in prices of onions - I would call that a concern. However, completely agree with the your opinion on the Government being held responsible for things that are not in its hands. I don't remember a Finance Minister of the country almost pleading on the television and requesting the citizens not to buy gold. We doesn't media highlight that?