Even without getting into any quantitative measure of vulnerability, it is quite clear that the rupee is under pressure. In the last one year, it depreciated by over 10%, has crossed the psychological marker of ₹80 to a dollar, and India’s foreign exchange reserves are down by more than $100 billion.
The rupee is falling on account of two factors. The first is the widening current account deficit, mainly owing to the rise in the price of oil triggered by the Ukraine war. And the second is capital outflows, driven by a strengthening dollar on the back of aggressive rate hikes by the U.S. Federal Reserve.
Tantrums, but not of the taper variety
Having been at the helm in the Reserve Bank of India (RBI) during the taper tantrums of 2013, I have been asked in recent weeks whether India is heading into a similar crisis. I believe that is unlikely because there are big differences between the external situation then and now. For one, there was pressure built up in the exchange rate then whereas the exchange rate today is tracking fundamentals more closely. Second, India’s macro situation then was fragile because of year-on-year high fiscal and current account deficits. Most importantly, India’s current war chest of reserves inspires confidence that India lacked at that time.
Arguably, the pressure on the rupee has softened, if only modestly, compared to six months ago, because the price of oil which was ruling above $100 to a barrel has since dropped to $88, India’s monthly trade deficit appears to have come off the peak, and capital flows are stabilising.
This is by no means to suggest that India is slowly heading into a comfort zone. On the contrary, the country remains vulnerable on many counts.
At risk on different counts
By far the most important vulnerability stems from the current account deficit (CAD) — a broader measure than the trade deficit because it takes into account invisibles such as, for example, travel and tourism — is expected to widen to beyond 3% of GDP this year, higher than 2.5% that the RBI considers to be the safe limit. India can withstand a one-off overshoot of the CAD beyond the safety zone, but there can be no reassurance that it will soften soon given the Fed’s seeming commitment to continue hiking rates until inflation in the U.S. is tamed and there is the unlikely prospect of the Ukraine war ending anytime soon.
What accentuates India’s vulnerability is the fiscal deficit. For all the talk of fiscal consolidation, the combined fiscal deficit of the Centre and the States is still above 10% of GDP, possibly higher if the contingent liabilities, especially of the States, are also brought to the book. It is worth remembering that India’s severe balance of payments crisis in 1991 and the near crisis in 2013 were both consequences of fiscal deficits spilling over into the external sector. The twin deficit problem is still very much with us.
Some comfort is seen to be drawn from the fact that this is a global problem, and India is not in it alone; also, that the rupee has fallen much less than most currencies, including hard currencies such as the euro and the pound. That comfort is misplaced. Even if the problem is global, the consequences are domestic. Moreover, India’s fiscal situation is more stretched than that of most economies.
Quite justifiably, India has come to look upon its foreign exchange reserves as a buffer against exchange rate pressures. It cannot get too sanguine though. There are many metrics for measuring the adequacy of reserves; one of them is to see them as a ratio of GDP. That ratio which stood at 21% in March 2022 as a proportion of FY22 GDP has since declined to about 17% of expected FY23 GDP, not very much higher than the ratio of below the 15% it had dipped to during the taper tantrums of 2013.
Besides, experience shows that in times of pressure, market perceptions are shaped more by how rapidly the reserves are falling — the ‘burn rate’ — rather than the absolute level of reserves.
The ‘R’ word, it seems, is no longer a taboo; recessions in the U.S. and Europe look much more likely today than they did a couple of months ago. How will India’s fortunes change if that happens? Much will depend on the depth and the duration of the recessions, but for sure, India’s exports, already struggling, will be further hit. On the positive side, the international price of crude will soften and global financial conditions can be expected to ease. How these opposing forces will play off is uncertain, but my hunch is that on a net basis, a recession in advanced economies will hurt the country.
The Russian question, the RBI’s actions
In August, the RBI allowed domestic traders to settle their import and export bills in rupees. Although projected as a bold move to internationalise the rupee, it was essentially an effort to enable payments for the crude that India buys from Russia in rupees. That arrangement has not taken off so far; if and when it does, it can save up to $4 billion a month in forex outgo which will be a substantial relief in a trade deficit of $20billion-$25 billion right now.
The RBI has been intervening in the market — selling dollars from its foreign exchange kitty — to defend the rupee. Presumably, the effort is to prevent volatility but not target any specific exchange rate. Experience shows that any attempt to prop up the rupee against fundamentals will be a costly and futile endeavour. All the RBI can — and indeed should — do is to engineer the trajectory of the fall, not prevent the fall itself. There is in fact a good case for the RBI to allow some depreciation of the rupee. The real effective exchange rate (REER) of the rupee, which is a broader measure of its value against the currencies of India’s trading partners, is overvalued, suggesting some room for depreciation. If that movement towards equilibrium is allowed, it will support exports, restrain non-oil imports, and help narrow the current account balance.
For sure, a weaker rupee will be inflationary, but the RBI should deal with that with its monetary policy as it already is doing.
We live in a difficult world where macroeconomic management is hostage to global economic conditions. Former U.S. Treasury Secretary John B. Connally famously told his G-10 counterparts in 1971 that “the dollar is our currency, but it’s your problem”. That is even truer today because of deepened financial globalisation and the continuing hegemony of the dollar.
Even though a crisis is unlikely because of differences between the external situation then and now, India could still remain vulnerable on many counts
Duvvuri Subbarao was Governor, Reserve Bank of India (2008-13)