Rupee caught in global storms

The rupee continues to be vulnerable despite Government and central bank efforts to rein in the depreciation.

Efforts have been made to attract FDI, boost infrastructure spending, ease ECB norms, control investments abroad and reduce gold imports in order to contain the high CAD (current account deficit) -- and, in turn, curb sharp depreciation in the currency.

If we divide the factors that are impacting the rupee into domestic and international, we can figure out that while international economic issues are a matter of concern, it is the domestic economic weakness that is contributing to its ongoing depreciation --- despite several efforts to deal with these infirmities.

Then and now

Examining how we managed to put behind us earlier episodes of economic chaos, might be instructive in this regard.

Between 1980 and 1991, India was virtually a closed economy and post liberalisation a new financial phase set in.

But before this could begin, India faced an acute economic crisis due to a high current account deficit, sharp fall in foreign exchange reserves that could sustain only around three weeks of imports, currency overvaluation, and a tight credit market along with a political crisis.

What happened then stares us in the face today — we are not only facing a high current account deficit, decline in forex reserves and high interest rates, but also depreciation in the rupee alongside a difficult political situation.

Earlier bouts of depreciation were in 1997, 2008, 2011 and 2012. The rupee depreciated in 1997 on the back of a high current account deficit, high interest rates and a slowing economy.

In 2008, capital outflows and deceleration in exports pulled the rupee down. Receding capital flows brought down the rupee in 2012 and 2013.

While comparing these situations, we must keep in mind the fact that the international impact was lower at the turn of the century, but is extremely crucial in the present context.

The RBI is putting in its best efforts to control further weakness; an impact on the overall economic situation may be seen in the coming months. It is because of the conservative approach of the RBI that the Indian economy has bounced back from earlier crises.

It has been seen that despite theories of decoupling, India was impacted by the global recession in 2008-09. This is because the country witnessed an increased level of trade integration along with deeper financial integration.

The ratio of total external transactions (on current and capital account) to GDP indicates the level of financial integration.

In the case of India this ratio had more than doubled from just 44 per cent in 1998-99 to 112 per cent in 2008-09, thus suggesting that the Indian economy was well integrated financially with the rest of the world.

Financial integration is a stronger force today than ever before. Hence, the fear of a pullback in quantitative easing (QE) by the Federal Reserve has already led to capital outflows from India and other major emerging economies.

During June-August’13 alone, Indian markets have seen outflows to the tune of Rs 18,780 crore in equities and Rs 51,270 crore in the debt segment and during the same period, the rupee has averaged around 60 levels.

Apart from the capital outflows, the rupee is additionally facing the impact of a stronger Dollar Index, and as the yields on US treasuries rise, investors are moving away from Indian markets.

The fear among investors is that -- if this is the impact ahead of the Fed’s action, then what will be the result when the bond buying programme actually begins to taper?

The rupee has witnessed extreme depreciation in situations of economic crisis. Post the opening up of the Indian economy, financial and trade integration with the world markets increased substantially, thereby leading to high impact on the currency due to capital flows.

Since 2011, the rupee has been depreciating and from an annual average value of 46.6 in 2011, the currency weakened to 53.4 in 2012 and in 2013 to date, the average value has depreciated further to 56.34.

Growing dependence on global factors is causing the domestic currency to react in a volatile manner.

Policy responses

The rupee can stabilise only after domestic markets witness concrete policy responses to the current situation. Also, rupee volatility will come down once the world markets absorb the impact of the QE taper.

Coming back to the impact of capital flows, a high correlation between the rupee and FII flows is evident. Receding FII flows in 2013 have led to sharp depreciation in the average value of the rupee.

In previous years, the average currency value remained higher due to sustained capital flows.

The risk of further decline in capital flows of emerging and developing economies is expected due to the improvement in the US economy, which is supporting the decision of the Fed’s pullback.

Emerging and developing economies are witnessing a slowdown, as opposed to a pick-up in growth of the advanced economies, i.e. the US and the Euro Zone.

This reinforces concerns that the Indian economy is yet to witness the negative effects of an upcoming Fed action.

Due to this, the trend in the rupee is expected to remain bearish. This will continue till the markets settle with the fundamental shift in the global economy, and move forward into another newer financial era – sans the aggressive stimulus spending.

In the long run however, we are expecting the RBI’s measures to show results. Actions by the central bankers will help prevent excessive depreciation in the rupee.

(The author is CMD – Angel Broking)