Currency woes continue unabated

With conservation of external reserves in focus and little risk of domestic inflation, the rupee faces further depreciation.

In November 2014, even as the Narendra Modi euphoria continued, Goldman Sachs put out an international economic forecast, saying that the Indian Rupee would appreciate to Rs 62 to the US dollar. Japanese investment bank Nomura also came up with a similar forecast or even more bullish estimates for the rupee–dollar exchange rates, projecting that it would go as high as Rs 57 per US dollar.

In making these projections currency forecasters make a fundamental assumption, ceteris paribus (other things being equal). But what actually prevailed was Alia vero non ex paribus (other things are not equal). The result is that that forecasts fell flat. The rupee dropped from Rs 62 on April 1 in 2015 to Rs 68 this year.

This essentially implies that non-residents get more rupees for their dollars and NRI bank account holders earn more on their foreign currency deposits by way of currency depreciation. However, it also means that Indian citizens would have to pay more for their essential goods imports that include pulses, edible oils and even onions.

But the rupee’s woes in recent months are only partly due to domestic factors. Despite the weak monsoons and floods in some parts of the country, food prices have remained largely under contained. The consumer food price index has remained contained at 6.4 per cent for the calendar year 2015, unchanged from December 2014. As for core inflation (a price rise measure that excludes volatile commodities and fuel), it was in the negative zone at 2.8 per cent.

In turn it reflected on the Index of Industrial production as well, where industrial output showed a contraction of 3.2 per cent for November 15. If the negative wholesale price is a clue, the contraction is a pointer, the contraction may continue into December as well. Although industrial output may have decelerated, India remains among the fastest growing regions of the world. This year growth is likely to be 7.5 per cent according to Fitch Ratings, which is just lower than the estimated 7.8 per cent.

Clearly the factors, impacting currency movements are impacted by externalities than fundamentals. The external factors impacting rupee depreciation are largely capital movements. As on January 8, 2016, foreign currency reserves were a healthy $326.40 billion. But on the last day of 2015, it was even healthier at $327.82 billion.

The reduction in reserves implied at least $1.4 billion was spent on currency market interventions alone! The outflows were largely on account of selling by foreign portfolio investor (FPI) selling. The selling was driven by improved returns from the dollar treasury and bond markets that have turned attractive after sudden hike in interest rates by the US Federal Reserve Board in December 2015.

FPI selling on January 15 alone amounted to $305 million, of both equity and debt securities. The selling translates into a demand for dollars. The demand stems from FIIs exchanging their rupee funds for US dollars. In turn it led to a demand for the dollars as they repatriate the proceeds to their home countries. It is this selling that has partly influenced the slide of the rupee against the dollar. The result is that the rupee–dollar exchange rates have depreciated by about 8.5 per cent since April 1, 2015, or the beginning of the financial year.

On the face it, it does not appear to be a big depreciation. This is because of the difference in inflation rates in India and the United States. India’s consumer price inflation is 5.51 per cent. The US retail inflation is 0.5 per cent. Under normal conditions a one per cent inflation difference translates into an exchange rate impact of 0.8 per cent. Presently that difference is about 5.1 per cent on the basis of the consumer price index. Based on that number, the rupee should have depreciated by only about four per cent. Instead the depreciation was more than double that figure.

However, it is not just FPI flows alone that have influenced exchange rates. There are also other capital movements. They include repayments of foreign debt and redemption of the non-resident deposits. India’s external debt, according to the Ministry of Finance amounted to $ 483 billion. India’s external debt is presently $ 483 billion. External commercial borrowing (ECB) is $ 182 billion. It is the (ECB) component that normally causes turbulence in the foreign exchange markets. This is because the ECBs have to be serviced every quarter, which is approximately $8 billion this financial year, according to estimates by the Ministry of Finance.

Servicing implies repayment of interest and principal. The turbulence is also largely on account of the fact that many of commercial borrowers have their left repayment obligations unhedged. Some corporates prefer to leave exposures (debt-service payments falling due) unhedged ostensibly to save on costs and benefit if exchange rate appreciates. Ideally, for corporates with foreign liabilities, a rupee appreciation is beneficial since it reduces the cost of repayments. On the other hand, if the rupee depreciates, the reverse happens. This is precisely what appears to have occurred during the last few days of the December, when foreign payments fell due.

Foreign currency

Other factors have also played a role in the sharp currency depreciation. India also needs foreign currency to meet its payment of imports of raw materials, fossil fuels, coal for power generation, fertilisers and edible oils. International commodity prices have contracted sharply, during the last few months, translating into fewer dollars for meeting the payments. Economic growth targets have imposed their own payment liabilities. This is because high growth target projected for the year would mean high imports of fossil fuels.

Import of coal alone for power generation in the country would be about 176.4 million tonnes or about 15 million tonnes a month, this year, offset domestic production slippages Coal prices averaged, $ 51 a tonne, meaning India’s payment liability for imports would be about $ 900 million each month. This is in addition to petroleum imports that average about 4 million barrels per day.

Commodity price fall

What has also made the situation difficult is that India’s exports are also under pressure. If India has benefited from commodity price falls, it has also lost for the same reason, since the country is a large exporter of primary agricultural commodities. Coffee prices have fallen by over $ 1.5 a kg and tea by about $ 0.5 over the 2014 average prices. The price drops automatically shrink export earnings. Besides, export markets, mostly OECD, Middle East are on an austerity drive.

Consequently, Europe, America, West Asia, China and Japan are importing less. The austerity in export markets reflected in the 19 per cent export shrinkage for the nine months beginning April 2015. “We are facing difficult times as orders from the U.S. and Europe have dried up," said Mr SC Ralhan, President of the Federation of Indian Export Organisations (FIEO), referring to shipments to India's two largest markets. Worse, foreign currency inflows also appear to be slowing. Net foreign investment (portfolio and direct) declined to the US $ 0.1bn in the second quarter of this financial year (July to September) from US $ 7.8bn in the first quarter (April –June) 2015.

Foreign portfolio investments witnessed a net outflow of $ 6.4billion in this second quarter of this financial year (2015-16) compared with a net inflow of $ 9.8bn during the corresponding period of last year (2014-15).Consequently, the reduced inflows, limit the RBI’s ability to intervene in the foreign currency markets. Present about 11 months of imports are covered by the foreign currency reserves. If petroleum import prices further dip from the present levels, then import coverage would increase further, closer to 12 months.

Even so, intervening to support the rupee in the markets would mean bleeding of reserves, that neither the government nor the RBI can afford given the volatile global environment. Clearly, the option therefore appears to favour further depreciation of the rupee, especially since China has already devalued the Yuan. Foreign investors appear to have factored that in. In the Dubai Gold and Commodities February delivery contract futures was trading at Rs 70 to the dollar. With little risk of imported inflation, that implied more currency depreciation could very well be underway.


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