The rupee continued its decline against the dollar, a process that began more than two weeks ago. On May 22, it fell to an all time low of 55.47 to the dollar before closing at 55.40. The rupee had closed at 55.05 on May 21. A 35-paise drop over just one day is quite sharp by the standards of exchange markets. The sharp fall continued into Wednesday (May 23), touching 56 to the dollar.

Amidst all these, there have been very few explanations from the Reserve Bank of India and the government, which can be considered original. It is this apparent helplessness as much as the actual fall that is truly baffling.

One must remember that the recent rupee-dollar movements are being dictated by market forces and not induced by any RBI action. Recent declines, unprecedented as they are, have left policymakers nonplussed and scrambling for rational explanations. Failure to identify specific causes, in turn, suggests that countervailing policy measures, even if feasible at all, cannot be effectively targeted within a given time span.

There is, in any case, no causal connection between India's widely perceived recent macroeconomic declines and the sudden sharp fall of the Indian currency. It is true India's average annual growth rates have slumped to below 7 per cent and that it is highly unlikely that the heady 9 per cent plus GDP growth can be achieved in the near future.

Yet, a sub-7 per cent, disappointing as it is from the Indian perspective, is still commendable by global standards. That India suffers from the twin deficits — on current account and fiscal balance — is also well known. It is acknowledged that there has been a deterioration in these two parameters.

Falling rupee

The Finance Minister hopes to contain the fiscal deficit at 5.1 per cent of the GDP by March, 2013. Even if he succeeds, it will be way off the fiscal consolidation map that seemed achievable a few years ago. As for current account imbalance, it is feared that the deficit may be as high as 4 per cent of the GDP. The ‘comfort' levels are way below that — between 2.5 and 3 per cent.

But, like the decline in the GDP growth rates, a deterioration in key macroeconomic parameters of current account and fiscal deficits have been noticed for some time. News of these had percolated to every nook and corner of the market. Until recently these did not cause such a scare as has been evidenced more recently.

Reasons vary

So what explains the sudden free fall of the rupee? It is true India is not alone in its present predicament.

Many other emerging markets have seen their currencies lose value in dollar terms. But the reasons for the declines have tended to vary: they are invariably a combination of domestic and external factors. For instance, the risk aversion, which portfolio investors have developed in the wake of the festering eurozone crisis, has led to a flight away from nearly all emerging markets.

The weaknesses, structural or otherwise, in individual economies have tended to exacerbate the consequences of reverse dollar flows, resulting in a weakness of the domestic currencies.

But compared to its peers, India has certain negative features that may be considered unique. Stalled reforms, a widely perceived failure of governance and slowing growth have exposed India's vulnerabilities.

The government debt is at 68 per cent of the GDP, one of Asia's highest and higher than similarly rated governments such as Brazil. The sharp hike in petrol prices during the middle of last week — by as much as Rs.7.54 a litre — has several negative connotations. But above all, it is a rude reminder of the serious policy drift. If indeed petroleum prices had been freed from the government control, the hike in the prices would have been more gradual.

The petroleum marketing companies would have had far fewer reasons to kowtow to political constituencies.

Declining reserves

The suggestion to use the forex reserves — at present $290 billion — to stem the rupee's free fall is fraught with risks. The size of the reserves has been coming down and in any case offers limited cover in relation to the country's short-term external commitments. By far India's greatest vulnerability is the dependence on short-term capital flows to bridge the current account.

The stability of these flows has always been suspect, more so at a time like this characterised by extreme risk aversion and global uncertainty. The current account deficit itself shows no signs of narrowing. The yawning trade deficit, characterised by sticky imports and rapidly declining exports, is a major threat. Petroleum prices are expected to remain high and there is no way the import bill will come down.

Time and again, the Finance Minister has blamed the eurozone crisis.

Indeed, problems in Europe affect India in a number of ways: lower trade volumes, flight of short-term capital, European banks cashing in on their short-term IOUs of Indian corporates, to name the major ones. But very similar to India's macroeconomic problems, the consequences of a deteriorating euro crisis were well known.

In any case, there is no tangible explanation as to why they should affect India's external economy so violently at this juncture.

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