The rupee’s steep slide to the 79-to-a-dollar range is bound to impact importers, widen the current account deficit (CAD) and increase the value of India’s external debt burden. But how much of a problem is this going to be for the Indian economy, given that the rest of the world is facing economic challenges as well? Zico Dasgupta and Indranil Pan discuss whether the declining rupee presents a crisis or an opportunity, in a conversation moderated by Bharat Kumar K. Edited excerpts:
The declining rupee has several consequences. In sum, is it a crisis or an opportunity?
Zico Dasgupta: This is a matter of concern because the question of opportunity arises when one talks about the positive impact of the declining rupee on trade balance and net exports. That seems to be limited for two reasons. First, despite depreciation in the nominal exchange rate, the real exchange rate has not really depreciated in recent times and that is what matters for questions of trade balance and exports. Second, in the last two-three decades, the sensitivity of exports has been weak as far as changes in the real exchange rate is concerned. The depreciation is concerning — not exactly on the lines of the instability we have seen in Sri Lanka or other developing countries, but because it adds to the inflationary pressure and squeezes the purchasing power of those whose incomes are not linked to the crisis.
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Some predict CAD could rise to 4% of the GDP in the first half of this fiscal. Is this unhealthy or can we live with it?
Indranil Pan: A broad indication that we are working with at this time is 3% CAD as a proportion of GDP with the assumption that oil is at about $110 per barrel. If oil is at $120, the CAD goes up to 3.3%. From the RBI (Reserve Bank of India)’s perspective, the moment CAD crosses 2.5%, red flags come up. More importantly, rather than only looking at the CAD, we need to find out whether we have adequate flows on the capital side to bridge the CAD. And if we do, then even if the CAD is at 3%, it might not be very strenuous for the economy. Currently, because of the changing landscape in terms of the monetary policy cycle globally, emerging market inflows have dried up. There are more outflows from emerging markets. So, the RBI has to sell dollars in the spot market to contain the depreciation. Depreciation pressures are relatively more contained than in 2013. I don’t mean it’s time to sleep over it; definitely, you need to see in what ways the capital flow can be improved — RBI has come out with certain policies on that — or determine how the current account gap can be closed by reducing imports. There can be a natural adjustment: the higher inflation and tighter monetary policy domestically would dampen local demand. So, non-oil, non-gold imports are expected to be softer. Fears of a global recession could also lead to a downward bias in crude oil prices; that could be positive for the current account. But global slowdown may also pull down exports and that is worrying from the CAD perspective.
Zico Dasgupta: Right now, it’s not a crisis as serious as Sri Lanka’s, but it’s a matter of concern. Whenever the rupee or any currency starts depreciating, there is always an expectation of further depreciation, which can lead to further capital outflows. In that context, the central bank needs to keep an eye on the situation.
The RBI is said to be prepared to spend another $100 billion, if needed, to defend the rupee. If that happens, are we still in a healthy position?
Indranil Pan: In terms of how much reserves you need, there is no thumb rule to indicate that this is enough. Earlier, flows were adequate, the CAD was low and the RBI actually managed to mop up a lot of forex and built up reserves to about $635 billion. On the downside, again, there is no maximum extent to which you can reduce your forex reserves. But the RBI must watch the import cover of forex reserves; that has now fallen sharply as the import bill remains high and forex resources have depleted. The consequent impact on the rupee liquidity is another factor the RBI needs to watch.
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The critical issue for the rupee is not the level, it’s the volatility. If the depreciation pressure is gradual, in line with the fact that global monetary policy is tightening and other emerging market currencies are also weakening, the RBI shouldn’t mind allowing the rupee to also depreciate. We probably need to tell the corporates that they need a better hedging strategy when the currency is more or less stable or slightly appreciating. Currency depreciation is per se not bad, because it helps maintain the competitive advantage. Also, it helps keep a check on imports, because the moment currency depreciates, the prices of imported goods go up and that dampens the demand for importables. Of course, the demand for oil is relatively inelastic.
Zico Dasgupta: There is hardly any way to say that if you spend X amount of dollars, one is safe... think about the East Asian experience in the mid-1990s. Those countries were doing pretty well on the external sector or the economy. When the crisis hit and the capital started flowing out, it was not only a question of depletion of forex reserves; it was the expectation of depletion of the reserves combined with currency depreciation which led to the instability. So, as long as the capital doesn’t stop flowing out, it will always be a matter of concern for us, no matter to what extent the forex reserve is depleted.
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With a declining rupee, the value of our external debt has risen. Is that a concern?
Indranil Pan: It’s a tricky question. The point should be whether the ECB (external commercial borrowing) flows are hedged or not for currency depreciation. If they have been hedged, there is no problem. But if they have not, the amount to be repaid in terms of the rupee will have surely gone up. Companies will have to adjust it into the balance sheets and hence, we can see some squeeze in the balance sheets of some companies. Some companies may still look at hedging their near-term payables. In the Indian context, the bigger worry is short-term debt with residual maturity of three-six months. Depreciation next year may be slower, because the global atmosphere could have changed by then. And who knows? If the recession hits larger parts of the world, there can be a faster reversal of the current tightening than what we anticipate now.
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I’m not worried about the longer-term ECBs. Because if you take the average, the last 10 years have given a currency depreciation of only about 3.5-3.8%. The RBI has been trying to push ECBs by relaxing end-use and also increasing the interest rate cap for the ECBs. This will enable relatively lower rated companies to attempt to raise funds abroad.
Given the recent moves by the government and the RBI, have we exhausted policy options?
Zico Dasgupta: No. Of course, it is an exogenous shock, but it’s not that there hardly exists any policy instrument to deal with that, at least for damage control. First, why is the falling rupee a problem? It could result in instability, which is not the case at this juncture, but there is also a question of inflationary pressure. If we look at the nominal exchange rate and the real exchange rate, the latter has remained stable in India in the last two years or so, despite the nominal exchange rate depreciating. This means domestic prices are rising faster than international prices. As there are domestic factors related to the question of prices, policy actions might come in there. For example, how to ease inflationary pressure in the agricultural [sector], how to compensate those whose incomes are getting squeezed due to higher prices because their incomes are not linked to the prices... The RBI needs to ensure a mix of exchange rate adjustment and depletion of forex reserves to maintain some stability in exchange rates.
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What could the government or the RBI do differently if they could do it all over again?
Zico Dasgupta: Till now, the policy measure has been exclusively dependent on monetary policy. That has its own limitations. The interest rate is expected to stabilise the inflation rate primarily. But the trend in the Indian economy would suggest that the relationship between output and inflation rate, termed the Phillips Curve in literature, has been flat, in that the inflation rate changes for reasons other than demand factors. Those factors cannot be combated by interest rate charges. On the other hand, higher interest rates or higher repo rates have an adverse impact on output, which affects GDP growth. And that’s the reason why the RBI has predicted a fall in GDP growth in the coming days. What is needed is greater dependence on the fiscal instrument. There are only two ways to do that. The first is to increase corporate tax in some form, to finance additional government expenditures, particularly in compensating labour’s income. The second is to rethink fiscal policy rules – review to what extent rules we follow are relevant and useful in the current context.
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Historically, corporate tax rate changes have hardly had an impact on corporate investment rates over time. For example, in 2018-19 when there was a huge corporate tax concession, there was hardly any impact on the corporate investment rates. The other option would be to do away with different corporate tax concessions. At this point, such concessions amount to around ₹5 lakh crore. So, even if one squeezes that amount of concessions, there would be a lot of fiscal space available.
Indranil Pan: I would have been happier seeing [recent] policies coming through in the monetary policy commentary rather than a knee-jerk announcement in the middle of a month, for it affects the sentiment of the market and raises doubts on whether the RBI is running out of resources to defend the currency, which is not the case. These policies forming a part of the monetary policy statement might have led to a more balanced view by the market. The critical areas the government needs to look at are how to prevent inflationary pressures from getting more widespread. Today’s twin deficit problem in India, which was also there in 2013, is coming more from the fiscal side rather than the current account side. If you cumulate the fiscal deficit as a proportion of GDP and the CAD together, we are as wide today on the twin deficits as we were in 2013. Now, we are expecting CAD at around 3%; in 2013, it was around 4.5%. The critical action we need is more on how to manage government finances and have a course chalked out on how to bring the deficit and government debt down. The government’s outstanding debt is large and increases in interest rates will raise the interest bill. Correcting for fiscal imbalances will also improve the overall macro atmosphere and offer a positive signal to the external world, providing comfort to investors.
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What did you mean by rethinking policy rules?
Zico Dasgupta: Fiscal policy targets a specific level of debt to GDP ratio, i.e., it targets debt stability, and the job of the monetary policy is to target the output gap and thereby control inflation. Now, the intensity of the slowdown is such that the interest rate is unable to compensate for either the output growth rate or labour income, and now there is the added pressure of increasing interest rates. Fiscal policy needs to play a role in helping boost demand, but that is not exactly consistent with the present policy framework. By its very design, fiscal policy is meant to stabilise debt to GDP ratio, it is not meant to boost aggregate output growth rate or labour income. So, we need to think about the purpose of the fiscal policy rule given the crisis we’re facing.
Indranil Pan is Chief Economist at Yes Bank; Zico Dasgupta teaches Economics at Azim Premji University
