After unleashing some rather unpopular weapons of yore on the markets over the last month and a half, the Reserve Bank of India and the government find themselves in an unenviable situation. The very measures that were meant to protect the rupee have turned toxic and boomeranged. Both the rupee and the stock market indices continue their nosedive.
The increase in short-term rates aimed at draining liquidity failed to contain the falling rupee. Since July 15, when the measures were announced, the currency has depreciated 5.40 per cent, falling from Rs.59.89 to Rs.63.13 to the dollar, cocking a snook at the RBI. What the measure did though was to alienate corporate India further by impacting sentiment and raising fears of a rebound in medium and long-term rates. Indeed, some banks have already announced an increase in their base lending rate, signifying the rising cost of funds. Axis Bank raised its base rate by 0.25 percentage points to 10.25 per cent on Monday.
The damage could still have been contained if the central bank had stopped there. But the urge, and probably pressure on it, to control the rupee’s slide was so high that out came the next move that really stunned the markets: the restriction on investment outflows on corporates and individuals. That measure to control capital outflow ironically had the opposite effect as foreign investors panicked and voted with their feet. In the world of financial markets, perceptions matter as much, if not more than reality and the central bank’s measures were perceived as the return of capital controls. The result is the ongoing mayhem in the stock market with the Sensex losing a whopping 5.46 per cent or 1,059 points in just two trading sessions on Friday and Monday. The rupee had its worst day in more than a decade, falling by Rs.1.48 to an all-time low of Rs.63.13.
Pressing the panic button
The question that rises now is: did the RBI and government press the panic button much too soon? Hindsight is always 20:20 and it is easy to comment on the RBI’s actions, especially when you don’t have access to the information and data that prompted its actions. Yet, one needs to ask if the measures, especially the second set announced on the eve of Independence Day, were called for.
Of course, to be fair to the central bank, it can only do what is within its powers and that is using monetary policy tools; these cannot substitute for resolute action from the fiscal side, which is the government’s prerogative. Indeed, the comments of Prime Minister Manmohan Singh on Saturday at a RBI function couldn’t have been more apt. Dr. Singh spoke of the “possibilities and limitations of monetary policy in a globalised, fiscally constrained economy.” He may or may not have meant it as a dig at the central bank but the truth unfortunately is that there are indeed limits to what monetary policy can achieve in the absence of support from fiscal policy.
The root cause for the problems with the rupee and the current account deficit (CAD) are not so much to do with monetary policy as with prolonged neglect of the real sector of the economy. The truth is the UPA II government has failed to create a conducive environment for investment in manufacturing. Even as inflation was raging all the action to control it was on the demand side and not on the supply side, where the problems were.
Accumulating problems
Projects were held up for want of clearances related to land and environment even as power supply and other infrastructure constraints posed problems for those that were already operational. Exports fell for want of sympathetic policy measures such as interest subvention schemes to protect units in the medium and small-scale sector from high interest rates. Just imagine the dividends that a competitive exports sector could have brought in these times of a depreciating rupee.
A small example of what could have been is provided by the apparel segment whose exports grew by 12 per cent in June to $1.24 billion and by 11 per cent to $3.56 billion in the first quarter of this fiscal, according to the Apparel Export Promotion Council.
There are also other important factors for the high current account deficit such as the inability to arrest fuel subsidies, which meant that consumption growth continued unabated and hence oil imports continued to grow. Had the government even turned a small part of its focus on gold import to fuel subsidies, the import bill could have been lower.
There could also have been better appreciation of the fact that the falling trend in the rupee was also because of global capital returning to the U.S. in anticipation of improved economic prospects there. Capital, like water, finds its level and that level is where returns are best. The only way to combat such an outflow is to create conditions within India that will improve the prospects of returns. As any economist would tell you, it is futile to hold back or even be seen to be holding back capital against its will, especially in a world free of controls.
Thus, the basic mistake that policymakers made was misreading the symptom as the disease. The falling rupee and rising CAD are just symptoms of the illness which is the sustained fall in manufacturing growth in recent years and the consequent loss of investment opportunities for both FDI and FII investors, on the one hand and the resurgence in the U.S. economy, on the other. And the cure for both is the same: encourage the manufacturing sector by removing hurdles to investment and production. That will, in due course, get the rupee the respect it deserves.
