Throughout last week, the rupee continued to be under pressure, breaching the psychologically important mark of 60 to the dollar on Thursday. This pushed to the background a needed discussion on the reasons behind the rupee’s fall, and, perhaps, more importantly, whether the almost universally derided sharp depreciation can have some positive outcomes.

There is agreement that the rupee’s fall — by no means unique — was triggered by the perceived change in the U.S monetary policy stance.

A little less than a fortnight ago, Federal Reserve Chairman Ben Bernanke spoke of a possible withdrawal of the stimulus — the ultra-soft monetary policy that has kept short-term interest rates in the U.S. at historically low levels.

The Fed’s focus has been on the domestic economy. In the normal course, the June 19 statement of Mr. Bernanke was not intended for a global audience.

However, given the primacy of the dollar and the size of the unconventional policy measures, it was always clear that other economies would be drawn in.

In the event, the widespread anticipation on the eve of the announcement was justifiable even if the extreme reactions that followed were not.

For, not only was the announcement scheduled, its likely contents were known to all those watching the U.S economy. A withdrawal from the soft monetary policy was always on the cards. The question really was not whether, but when.

What has irked Wall Street and many other stock exchanges around the world is the decision to start pulling back (from the ultra-soft monetary stance) later this year rather than sometime next year as hoped for.

Exaggerated expectations

Clearly, it has been a case of exaggerated expectations. The policy designed to help the U.S. economy in the immediate post-recession period by making available inexpensive funds to domestic entrepreneurs could not drag on indefinitely.

Another point to be considered is that such a policy has benefited the outsized financial sector rather than the real economy.

Moreover, the financial markets are guilty of either ignoring or downplaying certain parts of the Bernanke’s statement which clearly linked the stimulus withdrawal to the U.S. economy strengthening — reaching some important signposts such as a fall in the unemployment rate, by specific dates. The Federal Reserve is acting from a position of perceived strength.

Normally, a positive outlook like this would be good for the global economy, and boosted, for instance, asset prices. The exactly opposite reaction indicates that the financial markets are fixated on the short-term, and for the present, at least, not only factored in the U.S. revival, which the Fed has announced.

Consequences for India

The sharp fall in the rupee might have stretched the options available to policymakers. The rupee has also dragged down with it the stock markets. This, of course, was inevitable. Plenty of cheap money from the U.S. has gone into Indian and debt markets.

With the Fed announcing a reversal, there has been a reverse flow. Investors, mostly the foreign institutional investors, are moving back to the U.S. by dumping Indian stocks.

External vulnerabilities

From a macro-economic perspective, developments following the Fed announcement have exposed the vulnerabilities of the external sector, which is heavily dependent on short-term flows to bridge the balance of payments.

In the short-run, the depreciation of the rupee increases the cost of imports and import substitutes.

Among others, it means, the cost of petroleum products would be higher but since it is invariably not passed on to domestic consumers, the level of subsidies and with it the size of the fiscal deficit will go up.

The threat of imported inflation will increase as inflation expectations harden.

Companies, which have borrowed in foreign exchange through external commercial borrowings (ECBs) but not hedged the foreign exchange risks, will suffer enormously.

Many banks will have to declare such loans as non-performing assets. Consequently, they will lend less to the productive sectors.

The government’s marked preference for encouraging short-termism should come to an end.

Thus, while a small minority see the plunge in the rupee value as being good for the economy — it will encourage exports — many others do not think so.

But one positive outcome is that the government will be put on guard against short-term measures.

narasimhan.crl@thehindu.co.in

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