Why is depreciating Rupee a cause of concern?

The next two years of policy action (or rather inaction) will decide the fate of India’s growth story. It will decide whether India will emulate Greece or Chinese economy in the next decade or so.  Everyone expected India to be rather isolated from the sovereign debt crisis and rather be the growth engine for global economy along with China. But it is turning out to be the other way around. Depreciation of rupee relative to dollar is making news and is hurting when it hurts the most.

Rupee Depreciation

Rupee is currently trading at its cheapest level (in nominal terms) relative to the dollar. It is currently the worst performing Asian currency and its fall has been fairly steep. The depreciation makes Rupee cheaper to buy for the foreigners and it makes the foreign exchange expensive to buy for Indians. This makes Indian exports cheaper and imports expensive. If we compare the valuation of rupee relative to dollar in terms of purchasing power parity (by accounting for inflation); the rupee is overvalued even at these levels.

Why a depreciating Rupee is a cause of concern?

• India is heavily dependent on oil imports. A weak currency makes these imports expensive. Worst part is that these expensive imports are heavily subsidized in India
• High interest rates in India caused a lot of domestic companies to borrow abroad in the form of external commercial borrowings. The depreciation is hurting these companies hard as the interest and repayment of principal in foreign exchange is expensive. Indian banking system is cramped up because of excessive borrowing program of the government to plug its burgeoning fiscal deficit. This limits their lending limits to the private sector and demand for capital by the government is crowding out the private sector. Thus private sector sought permissions to borrow abroad which is hurting them in the light of a steep depreciation of rupee
• Though India’s external debt is not at very high levels, still currently the external debt of USD 313 billion is almost equal to the reserves of USD 330 billion. This limits the active participation of RBI in the money market to stem the steep fall of rupee and keep it near its desired levels. The reserves are not large enough to afford a money market intervention.
• Due to a current account deficit position (imports more than exports) the economy is dependent on inflows from abroad. The dependence on foreign inflows is keeping the economy on tenterhooks as any further depreciation will make it difficult for the RBI to accommodate outflow of foreign exchange by the investors in case of a global event. RBI may have to put controls in that case which might result in a full blow exodus of capital from India; the worst case scenario; but highly likely possible.
• India is running a very high fiscal deficit; close to double digits if we take the deficit of states into account. The deficit is being financed by foreign investment. The dependence on foreign investment to bridge the fiscal hole which is on account of unproductive subsidies and concessions and not on account of productive capital investment risks a catastrophic fall in the currency in case of a global event.
• Every major economy from US to Japan and from China to Korea is trying hard to keep its currency cheap relative to other currencies to give its exporters an advantage over other countries. Cheaper currencies make exports cheaper and thus the advantage. In fact China has accumulated hoards of American Dollars only because it aimed to keep its Yuan undervalued relative to the Dollar. It thus continued to buy Dollar is the money market to keep Yuan relatively undervalued. A depreciating rupee is good news for Indian exporters and it makes Indian exports cheaper. But there is little to rejoice as India currently is a net importer. Policy inaction and lopsided decision making is ensuring no major impetus to Indian exports.