Behind weak rupee is a vulnerable external sector

The Indian Rupee is falling. We are within striking range of Rs.70 to the US dollar. In intraday trade, the currency touched an all-time low of Rs.69.10 in the last week of June. The nosedive has raised alarm as the rupee becomes the worst performer among currencies. There are many questions from every corner and some answers from Union Minister Piyush Goyal, who has cited “external factors” for this fall. It is true that the external climate has changed, oil prices are up and dollars may be moving out as the US economy picks up steam.

The official position of the Reserve Bank of India (RBI) is that it does not intervene in the market to “fix” a rate. But the RBI does fine drive the market with the stated objective of reducing volatility so that there are no spikes or surprises on the up or down side.

At its root, the demand-supply dynamic is what determines foreign exchange rates. Clearly, when the supply of foreign currency is more than the demand, the rupee appreciates and becomes strong. In the opposite case, which we are now witnessing, with demand for foreign currency more than the supply, the rupee has depreciated. The official position of the Reserve Bank of India (RBI) is that it does not intervene in the market to “fix” a rate. But the RBI does fine drive the market with the stated objective of reducing volatility so that there are no spikes or surprises on the up or down side.  This means that in the current situation, the RBI will be selling dollars to hold the rupee from sinking to Rs.70. The RBI uses the country’s forex reserves to do so.

Accumulation of reserves has been a policy since the 1991 crisis when the country was on the verge of a default. According to the latest data, the outstanding forex reserves (as on June 22, 2018) aggregated USD 407.82 billion, implying that over the years, the RBI has purchased dollars in a net sense and has built up these reserves. However, forex reserves have declined by USD 16.73 billion over March 2018, reflecting (at least in part) the sale of forex by RBI as the rupee depreciated, mostly during April-June 2018.

These reserves are seen as a “war chest”, and market expectations are growing that the government and the RBI will use it more freely to defend the rupee. This is not without its risks.

India’s forex reserves come at a high cost, as they are mostly debt capital flows (by and large chasing higher interest rates in India), like External Commercial Borrowings, or ECBs, and Non-Resident Indian (NRI) deposits.  A substantial part comes from trade credit, which represents letters of credit financing imports, particularly oil. For example, during 2017-18, our total capital flows on a net basis were around USD 91.4 billion, out of which USD 58.4 billion (as much as 64.4 per cent) are debt flows. How much of these high cost reserves must be burned to defend the rupee (or for that matter pay for oil, which is an unavoidable bill) is a tricky question.

The fact remains that we import more than we export. India’s Current Account, comprising goods and services (exports and imports) and workers’ remittances (income account) is persistently in deficit. Latest data indicate that for the full year, the Current Account Deficit (CAD) increased to 1.9 per cent of GDP in 2017-18 from 0.6 per cent in 2016-17. Consensus is that the Current Account Deficit in 2018-19 could be in the range of 2.6 per cent to 2.8 per cent of GDP. CAD at this level is not sustainable.

While the forex reserves is a cushion to meet the net outflows in the Balance of Payments, it may be reiterated that this approach is purely short term and unsustainable primarily because India’s forex reserves are mostly debt and costly.

This is on the back of a widening of the trade deficit, which has increased to USD 160 billion in 2017-18 from USD 112.4 billion in 2016-17. The oil deficit (import of crude minus export of refined oil) accounted for around 44 per cent of the total trade deficit.

Clearly, oil prices play an important role. The currency volatility was primarily on account of outflow of dollars due to a higher oil import bill as oil prices moved up. In April 2018, the oil import bill in dollar terms on a year-on-year basis saw an increase of 41.5 per cent when according to World Bank “pink sheet” data, the crude oil price recorded an increase of 35.5 per cent.

This is not for the first time such a situation has occurred nor will it be the last. Oil demand is inelastic and oil price is unpredictable. Sometime back, there were views in official circles (as recorded in the 2016-17 Economic Survey) that oil prices would not increase beyond the level of USD 50 per barrel. The authorities thus developed a sense of complacency.  The situation took a ‘U’ turn as the US turned protectionist, alongside effective cartelisation by OPEC, sanctions on Iran and uncertain developments in Venezuela. This is not a ‘VUCA’ (volatile, uncertain, complex, ambiguous) world for nothing!

While the forex reserves is a cushion to meet the net outflows in the Balance of Payments, it may be reiterated that this approach is purely short term and unsustainable primarily because India’s forex reserves are mostly debt and costly.

Data show that short-term debt on a residual maturity basis (i.e. longer term debt obligations due for repayment over the next 12 months and other short-term debt) constituted 42 per cent of total external debt at end-March 2018 (41.6 per cent at end-March 2017) and stood at 52.3 per cent of foreign exchange reserves (53.0 per cent at end-March 2017). Thus, two-fifths of the reserves are due for repayment soon. The forex cover for external debt and import was 80 per cent and eight months, respectively. These three indicators together make a strong case for cautious use of forex reserves to defend the weak rupee.

It is also time to abolish the scheme of export duty drawback, which has been a source of litigation and a drag on revenues. Similarly, the ‘Make in India’ scheme and a 100 per cent Special Economic Zone need to work in real terms to help kick up a variety of exports.

What is the solution? One important step is to keep the Current Account Deficit at a sustainable level and financing it in a non-disruptive manner. This means we need higher net flows from Greenfield Foreign Direct Investment, or FDI, which should be not less than 1.5 per cent of our GDP.  Our overdependence on workers’ remittances and software services though has helped to reduce trade deficit but at the same time has come in our way to develop our merchandise exports.

Our export promotion policy needs to be revamped with a focus on commodities having an elastic demand and destination with countries where tariff and non-tariff barriers could be negotiated. It is also time to abolish the scheme of export duty drawback, which has been a source of litigation and a drag on revenues. Similarly, the ‘Make in India’ scheme and a 100 per cent Special Economic Zone need to work in real terms to help kick up a variety of exports.

(Rattanani is a journalist and Pattnaik is a former Central banker. Both are faculty members at SPJIMR)