Sixth Pay Commission: The grim scenario of Rupee

Sixth Pay Commission: The grim scenario of Rupee

When the rupee was appreciating last year, it was widely believed that the upturn was here to stay. Foreign investments came

rushing to India, lured by its strong economic growth and low inflation. Even Indian corporates went overseas like never

before, borrowing heavily to fund acquisitions, as well as various expansion projects.

So, when the tide turned, it was a rude awakening for India Inc. Today, India is more integrated with the global economy

compared to a decade ago and the rupeedollar exchange rate has a huge bearing on India Inc’s growth prospects.

India continues to be a net importer of goods, especially capital goods and key industrial inputs. A costlier rupee raises

project costs and affects the rate of investment, which impacts economic growth. Besides, depreciation in the rupee reduces

the financial returns of foreign investors, reducing the relative attractiveness of India as an investment destination.

Given this, if we want to have a view on India’s growth story, it becomes necessary to understand the moves being made by the

rupee.

Why the rupee depreciated suddenly is an interesting question. The most obvious reason is the global financial crisis and the

ensuing massive unwinding of foreign portfolio investors to fund their domestic liquidity requirements. However , there have

been subtle changes in the economy over the past few months that have been hinting at a weak rupee.

India’s inflation spurted to double digits in June ’08 — higher than the rate of economic growth — on the back of high crude

oil and commodity prices. At the same time, the government’s decisions to raise subsidies rather than pass on the high global

prices of crude oil and fertilisers have dramatically increased the fiscal deficit.

Besides, the government has to make provisions for waiving agricultural loans, handing out the Sixth Pay Commission awards

and other welfare schemes launched in the recent past.

According to various estimates, these measures are expected to push India’s fiscal deficit to nearly 8% of the gross domestic

product (GDP) — the highest ever in nearly a decade. A bigger fiscal deficit translates into an equally huge trade deficit,

which puts downward pressure on the rupee. Till such a time these worries are addressed extensively, the downward pressure on

the rupee is likely to continue.

US AND THEM

It is not just the rupee, which has taken a thrashing from the sudden exit of foreign capital. Other emerging markets such as

Brazil and Russia have also witnessed a depreciation in their currencies — sharper than India’s — over the past few weeks.

While the rupee lost around 7.5% of its value from the beginning of July ’08, Brazilian real lost 20.6%, Russian rouble fell

10.3% and South Korean won depreciated by 16.9%. China is the only country whose currency has appreciated against the dollar

over a period of time.

THE SLIPPERY ZONE

While the outflow of the so-called ‘hot money’ has hit the rupee hard, the continuing liquidity problems overseas are adding

fuel to it. The foreign branches of Indian banks are suddenly finding it difficult to roll over short-term loans taken from

local banks.

In such cases, they are left with no other option, but to raise the necessary foreign exchange (forex) in the domestic market

by selling rupees, which adds to depreciation in the rupee.

LIQUIDITY WOES

The Reserve Bank of India (RBI), which overseas the domestic money supply, also monitors the supply of forex in India, so as

to smoothen out the erratic movements by keeping the markets wellsupplied and liquid.

However, RBI’s ability to intervene in the market is limited. The level of RBI’s forex reserves, which were on a secular

uptrend till May ’08 to reach $315 billion, have been waning since then.

Current forex reserves of $292 billion indicate a 7.3% drawdown from the peak, but they are still at very high levels,

considering India’s history of having reserves equivalent to around 12 months of imports.

But forex reserves have to be used carefully because they play a key role in maintaining the general confidence in the

currency. The structure of India’s foreign capital inflows has changed dramatically in the past few years.

While India’s total capital inflows have increased at a compounded annual growth rate (CAGR) of 58.4% over the past five

years, the hot money inflow — capital coming in through portfolio investments and short-term credit — has grown at 89%.

Hazy Future

During FY08 alone, nearly $46.8 billion of hot money flowed into India, representing 43.3% of India’s net capital inflows of

$108 billion. Since hot money can be easily pulled out at short notice, its large presence in the economy is a potential

danger. The boom in the economy and the stock market in earlier years led to its rising influence. But with things not so

smooth any more, it increases the risk of a sudden exodus of foreign capital.

Similarly, at times, RBI’s ability to intervene in the forex market gets restricted due to liquidity problems. When the rupee

is being sold off and losing value, RBI needs to sell dollars to support the rupee. This reduces liquidity in the banking

system.

So, it needs to be careful that its forex market operations do not leave the domestic financial system dry. Non-food credit

growth has reached 25% despite high interest rates due to heavy borrowings by oil and fertiliser companies.

RBI has taken steps to address liquidity problems. It started a second daily liquidity adjustment facility for banks and also

allowed them to dip below the mandated 25% statutory liquidity ratio requirement by one percentage point. In a bid to attract

more foreign currency, RBI has hiked interest rates on foreign currency deposits by 50 bps.

MACRO MIX-UPS :

The Indian economy is not in good shape. Growth in IIP has slowed, while inflation has soared. During the first five months

of FY09, fiscal deficit has already crossed 87% of India’s full-year forecast. The spurt in global crude prices has

single-handedly increased India’s trade deficit.

Crude prices jumped to an average of $120 in the first half of FY09 from $70 in the corresponding period of previous year.

So, India’s oil import bill swelled 77% in August ’08 to $11 billion and by 60% to $46 billion during April-August ’08. In

view of this, India’s export growth is falling short of the growth in imports. The resultant trade deficit is likely to touch

$125 billion for the whole of FY09.

There appears some light at the end of the tunnel on this count. Crude prices have retraced nearly one-third from their peaks

to fall below $100 per barrel and are expected to remain range-bound . In the medium term, domestic availability of natural

gas and crude oil is expected to increase substantially as RIL’s oil fields in Krishna Godavari basin and Cairn’s Rajasthan

fields begin production. Both these factors will ease India’s crude import bill and reduce the fiscal deficit. A simultaneous

meltdown in the commodity market will also alleviate inflation.

NO CLEAR VIEW, YET:

The recent fall in the rupee, led by withdrawal of foreign portfolio investors from India, may not be rectified till

stability returns. The global scenario is uncertain.

India also needs to fight its own woes — high inflation, widening current account and fiscal deficits and slowing economic

growth — besides absorbing repercussions of the global turmoil. The Indian economy’s ability to re-emerge as an attractive

investment destination will determine the rupee’s upward movement. Till then, the rupee is likely to remain under pressure.

(Inputs by Pallavi Mulay and Shakti Shankar Patra)


Source: http://economictimes.indiatimes.com/