[Editorial Analysis] Dealing with external sector vulnerabilities

Mains Paper: 3 | Economic Development

Prelims level: External sector

Mains level:  Besides the economic management, the politics of a weaker rupee will also need careful handling

Context

• The rupee’s steep decline makes for irresistible headlines.

• With the general election and a slew of state polls between now and May next year, it is as much a political issue as an economic one.

• It affects everything from fuel prices—a perennial cause of concern for the common man—to financial markets.

• Monday neatly provided examples of both.

• While opposition parties were protesting against higher fuel prices.

• The rupee weakened further by about 1% in trade, which also led to a wider sell-off, both in the bond and stock markets.

• But the heat and noise should not distract from what the current scenario tells us about the medium- and long-term picture.

What are the reasons for weaken rupee?

• The reasons for the rupee’s 13% depreciation against the dollar since the beginning of the year are well understood, it is perhaps the recent pace that has surprised the market.

• The weakness is likely to continue due to a variety of factors.

• The current account deficit (CAD) widened to 2.4% of gross domestic product in the April-June quarter.

• The wider emerging market sell-off is also affecting capital flows.

• Foreign portfolio investors have sold Indian assets worth over $8 billion so far this year, compared with a net purchase of over $30 billion last year.

• Further, the financial condition in global markets is expected to tighten.

• The pick-up in wages and prices in the US means that the Federal Reserve will continue to increase interest rates.

• Higher interest rates in the US will affect capital flows to emerging market economies and make things difficult for countries with higher CAD.

Current scenario

• In fact, the 36-currency export and trade-based real effective exchange rate index was at 115 in July, showing significant overvaluation.

• Some of it has now been corrected.

• Lower crude prices in the last few years resulted in overvaluation, which affected the tradable sector.

• Therefore, the ongoing depreciation will help revive activity and contain the CAD. But the recent pace of decline suggests that the adjustment needs careful management, as markets tend to overshoot in the short run.

• The flip side is that the depreciation in the rupee will have inflationary implications.

• Therefore, the chances of a rate hike in the October review of the monetary policy look very high now.

• Higher interest rates will help take some pressure off the rupee but increase the cost of money.

• Higher interest rates may also moderate growth, though some of it may be warranted to contain demand pressure, as is being reflected by higher core inflation and CAD.

Challenges for government

• The politics of a weaker rupee will also need careful handling.

• Attacks on the government will only increase as we get closer to crucial assembly elections towards the end of the year.

• The Rajasthan and Andhra Pradesh governments have already reduced value added tax on fuel.

• The Union government, on the other hand, has done well so far by avoiding tax cuts.

• However, it remains to be seen how it handles the political pressure in an election year.

• Any significant reduction in taxes will either affect capital expenditure or increase the fiscal deficit.

• Deterioration in government finances will increase macroeconomic stability risk and put more pressure on the rupee.

Way forward

• Indian policymakers also need to address structural issues to avoid recurring problems on the external front.

• India will continue to depend on oil imports, it needs to push exports to keep the trade balance in control.

• Sustained higher CAD will only increase India’s dependence on foreign debt.

• Further, policymakers need to revisit the way India manages foreign flows so that prolonged periods of real appreciation, which affect external competitiveness, can be avoided.

• Additionally, India needs to increase domestic savings to fund growth.

• The fiscal deficit of the Central government has come down in recent years, the combined deficit continues to remain elevated.

• Further tightening will be required to boost private sector investment and push growth in a sustainable manner.

• India needs to further strengthen its economic fundamentals to be able to attain higher sustainable growth and avoid recurring external risks.