The Indian Rupee - Quo Vadis?

This article appeared on CNBCTV18.com on 28th June 2018

https://www.cnbctv18.com/economy/where-is-the-indian-rupee-heading-the-rupee-story-quo-vadis-209641.htm

The rupee story – quo vadis?

So how will the ongoing INR story likely play out?

Like we always do, lets begin with a prayer. Let’s pray that Trump’s Iran, trade and other theatrics don’t put us in a pickle. That crude oil prices quickly correct back below US$60 a barrel. That investors don’t discover still more reasons to scramble out of emerging markets and India. 

If our prayers are answered, we can pat ourselves on our backs, scoff at the naysayers, declare that everything is fine, and again kick our large can of issues around exports, imports, and external and internal imbalancesdown the road. 

What if our prayers are ignored? We’ll live through interesting times – again. 

The vulnerabilities

On the external side, our core permanent balance across our current account and foreign direct investment deteriorated to a deficit of US$18B in fiscal year 2018 (FY18). Oil was not the only culprit – disappointing export growth, rising gold and electronics imports, and a declining net FDI all contributed.

This permanent balance could further deteriorate to a deficit of US$35B in FY19. That’s about US$3B of core outflows every month.

In the last fiscal year, the core outflow was more than amply covered by larger, opportunistic, reversible inflows including foreign portfolio investment (FPI) in debt, net exporter selling, and other speculative, carry-seeking positions. These flows strengthened INR despite the deteriorating core balance, and likely hurt our current account further.

Reversible flows are fair weather friends. With global and domestic macro sentiment deteriorating, we have seen $8B of debt FPI outflows this fiscal year, and US$1.5B of NRE outflows in April 2018. 

Between FY14 and FY18, we allowed $120B of reversible flows to come in. Not all of this will reverse, and the RBI still flaunts large FX reserves of well over $400B. But large waves of panicky currency outflows test our resolve and market savvy much more than inflows do.

The response playbook

So what will the RBI do? MPC decisions and RBI FX intervention impact the external sector, but there isn’t a well-articulated policy framework or debate around this. 

North Block will of course be concerned about INR depreciation. Sensational headlines around INR weakness and cartoons featuring petrol pumps are guaranteed to make our Babus and Netas wince. One way to spare the voter, for now, would be to take the stress onto the fiscal deficit instead – but that brings its own challenges. The other short-term solution, and Delhi does focus a lot on the here and now, would be to instead control the rupee.

Expect, therefore, that RBI will likely continue to flex its currency reserves with a brave face. They may already have intervened to the tune of $20B or more this fiscal year. 

But what if the negative sentiment builds up further? We can guess how things would play out then. 

The crisis contingency playbook

Sadly, our institutions will blame the crisis on the external trigger and everyone else except themselves. But whatever the proximate cause, we would have collectively put ourselves in a vulnerable spot with unaddressed external and internal imbalances – including a suffering external trade sector, an accumulation of reversible flows, a rising revenue deficit, and a floundering banking system. 

We will then await the next masterstroke(s) that our powers-that-be conjure. In 2013, it was a 300 bps policy rate hike, followed by RBI’s subsidized swap scheme to bring in non-resident (FCNR) deposits. These and other such homegrown remedies could be on the table, never mind the large hidden costs and imperfect science that they involve. 

We will emerge out of any crisis, as we always do. Notwithstanding our policy and administrative deficiencies, India’s true long-term potential is robust enough to bail us out. 

Strangely therefore, whether our prayers are answered or not, the final outcome could end up the same. We will likely end up eventually patting ourselves on the back, and kicking the can down the road. 

If only we looked beyond the short-term

We can live up to our long term potential much better if we addressed core issues head-on. These will take time to resolve, and will require hard work – a departure from the quick fixes that we usually look for.

Our exporters face challenges around infrastructure and ease of doing business, and these need to be addressed. On imports, our domestic industry needs help – we have to find a way of making smartphones and other widgets in India. 

On capital flows, we have to make some of the reversible flows such as FPI in debt more permanent and productive. The recent set of steps to allow more short-term FPI debt investments risks the opposite. Inclusion of our debt in global bond indices will take a long time, but will be well worth the effort. 

On banking, while we’re progressing on recognition of the true stress, we now need to recapitalize banks (even further), resolve bad loans, and restructure banking. Essentially, Delhi needs to dust off the P J Nayak report and implement it – and eventually give up the control it exercises over public sector banks.

Besides legislative and executive remedies, on the policy front, we should review our monetary policy andcurrency intervention framework. Trade and stable capital flows need a competitive rupee. Our current policy framework brought about the vulnerability of accumulated reversible flows, and an overvalued rupee. We need a policy framework that at least recognizes and debates external and internal imbalances better. 

Will someone volunteer to bell the cat please?