It is ironical that a likely recovery of the global economy led by the US, which the world had been anxiously waiting for, should usher in economic turbulence for India. But that is what has happened.
An upbeat prospect for the US economy has led to global money managers pulling money out of emerging markets such as India and Brazil. Indian debt markets saw an outflow of $486 million of foreign money between May 1 and June 10 as fund managers sought investment opportunities in the US.
The impact of this trend showed up most prominently in the foreign exchange market. The rupee shed some 10 per cent against the US dollar between May 1 and June 11, when it closed at a record low of Rs 58.92. "In India, we have to contend with this external contributor to our volatility," says Ajit Ranade, President and Chief Economist of the Aditya Birla Group.
Contributing to the rupee's fall were reports about the possible winding down of the US' Quantitative Easing (QE) programme. QE, a series of monetary stimulus packages unveiled to revive the US economy, had led to across-the-board rallies in most asset classes and markets globally.
As the US economy begins to improve, the country's stimulus packages will be gradually rolled back, with negative implications for emerging markets like India.
Finance Minister P. Chidambaram issued a media statement on May 23 to calm the financial markets. He chided the market for misinterpreting the US Federal Reserve Chairman Ben Bernanke's remarks on the QE programme. Bernanke had clearly indicated he would continue with the monetary stimulus in the foreseeable future, Chidambaram stressed.
But the finance minister's media statement failed to pacify the markets - the rupee continued to slide. "There will be volatility," says Harihar Krishnamoorthy, Treasurer at First Rand Bank. "It is a global phenomenon."
The rupee's depreciation over
the last six weeks could mitigate the positive impact of moderating inflation in India. Inflation dropped to 4.7 per cent in May, the lowest in over three years.
A weak rupee makes imports costlier, stoking inflation, and will also lead to a further widening of the current account deficit (CAD) - the difference between a country's total imports of goods, services and transfers and its total exports of these.
N.R. Bhanumurthy, Professor at the National Institute of Public Finance and Policy, explains that depreciation in the rupee offsets the advantage of oil prices remaining around $100 a barrel. Oil makes up the largest component of India's imports and accounts for about a third of the total. A rising oil imports bill will put pressure on the fiscal deficit as well, since the government sells diesel, kerosene and domestic cooking gas at subsidised rates.
"There's pressure on fiscal deficit as well as on inflation," says Bhanumurthy.
The Reserve Bank of India looks
at the fiscal deficit and inflation numbers closely while taking decisions on monetary policy. In the current calendar year, RBI has cut interest rates thrice, as it seeks to boost demand in a slowing economy. "RBI has to now weigh its decision on a rate cut in the light of rupee depreciation."says Ranade. Recent developments might prevent the RBI from easing monetary policy aggressively.
Even exporters may not benefit from a weak rupee. According to Bhanumurthy, exchange rate swings have a disproportionate impact on India's imports as compared to exports.
"Imports are more sensitive to exchange rates than exports," he says. Exporters argue that currency depreciation has at best short term benefits for them. "It makes no difference in the long run as imported raw materials get costlier and customers ask for lower prices," says M. Rafeeque Ahmed, President, Federation of Indian Export Organisations.
With international developments beyond Indian policymaker's control, what domestic factors are likely to influence the rupee?
June's trade deficit number assumes significance as there are early signs that gold imports may be moderating. Gold accounts for about 10 per cent of India's imports.
According to Raghuram G. Rajan, Chief Economic Advisor of the Finance Ministry, between May 1 and May 20 gold imports averaged $135 million a day. Subsequently, in the first week of June, it averaged $36 million a day. If gold imports taper off
, it will go a long way in lifting the pressure on the rupee.
The fiscal deficit has also been brought under control over the last year, which augurs well for the rupee. Chidambaram beat market expectations by restricting it to 4.9 per cent of gross domestic product in 2012/13.
Ranade feels the finance ministry should supplement its control of fiscal deficit by a series of small measures such as expanding foreign direct investment limits and lowering withholding tax on foreign investment in Indian debt to prop up the rupee. That is precisely what Chidambaram promised on June 13. "I am looking forward to more reforms," he said.