Rout of the rupee

IFR Asia India Report 2012
10 min read

The rupee’s 25% slump against the US dollar in 12 months is an alarming illustration of India’s waning global appeal. The volatile currency is making it tough for India’s importers and exporters, while forex markets do not see a reversal any time soon.

A shopkeeper poses for a picture as he counts Indian currency notes at his shop in Jammu.

Source: Reuters/Mukesh Gupta

A shopkeeper poses for a picture as he counts Indian currency notes at his shop in Jammu.

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Is the Indian gravy train, which was once running along smoothly, about to be derailed? The rupee’s recent fall has set alarm bells ringing. In the past year, it has plunged precipitously, more than 25% against the dollar, roiling currency markets in the country, driving up import prices and adding to the persistent problem of inflation.

Most worrying for India, the recent fall has come about even without an obvious cause for concern, such as the Lehman Brothers crisis, which had threatened a severe credit crunch the world over. At that time, the rupee also dropped around 25%, but all major Asian currencies were affected.

With that kind of trigger missing, the present situation is quite different. Is the falling currency a tell-tale sign that India’s economy is shrinking?

Even when the dollar is not at its best, the Indian rupee has still been the worst-performing of Asia’s key currencies with the Korean Won, the Indonesian rupiah and the Malaysian ringgit having fallen about 7%–10% against the dollar.

For rupee watchers, the situation has set alarm bells not just tinkling or ringing – but clanging. The rupee is in a precarious situation and forex experts have their fingers tightly crossed.

“The rupee has its own weakness. Despite the international factors that have not been positive for the US dollar, the rupee has been unable to track the weakness in the US dollar. This signals that the market for the rupee is inherently weak,” says India Forex Advisors CEO Abhishek Goenka.

Had this been any other time, it would seem like the Indian economy were jostling for a competitive spot in the global economy. Competitive devaluations to boost exports and curtail imports are, of course, nothing new for emerging-market economies, such as India.

However, the swift and sharp decline of the rupee in recent times is not at all about increasing the Indian economy’s global competitiveness, but about how badly managed the country’s macroeconomic situation is turning out to be – and how, perhaps, it is slowly getting out of hand.

Myriad of problems

Once revered for its growing strength and clout in the world economy, India is now beset with a myriad of problems – a ballooning fiscal deficit, crumbling infrastructure (an increasing number of power failures and collapsing bridges), coupled with a government unable to usher in crucial reforms to ease fiscal pressures.

“Depreciation has been swift and the Indian macroeconomic situation has not had enough time to adjust to the sudden fall in the rupee,” says Tata AIA Life Insurance CIO Saravana Kumar.

“The drop has bloated the current-account deficit and increased the cost of sticky oil imports, hugely impacting the fiscal deficit. It also inflames inflationary pressures, clearly seen from the fact that India has not benefited meaningfully from the softness in global commodity prices.”

One saving grace has been the surge in portfolio flows into India. Without those, analysts believe the rupee would have tottered even further. Since the beginning of the year, overseas institutional investors purchased equities worth nearly US$12bn, and debt close to US$9bn. This has alleviated pressure on forex markets, but has not had a positive impact on the rupee. That is because the widening current-account deficit has knocked India’s fore situation off balance.

Says Goenka: “I don’t think the fairly good portfolio inflows suffice to manage the current-account deficit. People compare it with last year and previously, but the point is that, earlier, the current account was 3%. Now, it is at 4%. So, obviously, the money that is coming in is not in the same proportion.”

The crumbling rupee has heightened problems for businesses in India. Chief among them is that the cost of hedging and doing business has gone up, as issuers of forward contracts in rupees charge a premium to compensate for the higher volatility.

So great is the volatility that businesses have been postponing hedging decisions since hedging costs have shot up. When the rupee was stable, the cost of a typical forward contract for importers was around 2%–3%. This has now gone up to around 4%–6%.

“On average, hedging costs are up around 50% over last year because hedging costs go up when the degree of volatility is high,” says Kuntal Sur, director of risk management at consulting firm KPMG. “So, businesses are trying to hedge on an incremental basis and riding the curve. Some companies are hedging very short-term obligations, such as their six-month requirements, keeping their long-term requirements still open.”

The falling rupee has not only resulted in import costs shooting up, but has also squeezed margins as many companies just are not able to pass on such higher costs. Businesses that were built solely on trading, particularly in agri-commodities, and those that increased business manifolds in the last couple of years due to a rising rupee, are now shrinking.

Most of them are balanced on wafer-thin margins, banking largely on a stable and, in some cases, an appreciating rupee to secure better credit terms from banks and importers.

Even overseas market watchers have seen that large IT exporters are lamenting that most of their conversations with overseas customers are not about pricing or volumes, but about India’s rising country risk with credit rating agencies.

International agencies have been warning of India’s worsening fiscal and current account situation for some time, and a downgrade may well further exacerbate the capital flight and trigger another bout of weakness in the Indian currency.

Tellingly, analysts point to these challenging times for India. The balance of payments in India’s capital account could play havoc with the nation’s finances if net capital flows do not swing India’s way and if global risk sentiment does not improve further.

Moreover, the government is raising the limits on debt investments in heightened efforts to woo foreign investors, but that has merely aggravated the foreign indebtedness. Foreign debt has ballooned from about 4% of GDP in 2008 to around 14% in 2012, according to Nomura.

Says Sonal Varma, Nomura economist, ex-Asia: “Basically, foreign assets are flat, and we already have huge debt and are inviting even more. We are adding on to the risk of rollovers in the future.”

One vital factor that may well determine the way the situation plays out is short-term movements of the rupee. At the time of writing, the Indian currency was hovering at around Rs56, not much of a comfort for the economy.

For now, most market watchers reckon that, for the short term, the rupee appears to be fairly stable due to strong foreign inflows and the measures India’s central bank has taken to stem the plunge.

Says Kumar: “We believe that the rupee, at current levels, is very close to its fair value and the 25% depreciation in the last year has corrected the earlier overvaluation to a large extent. From here, we have a positive bias on the rupee for the next six–12 months and we could see it trading at around 53–56 in the medium term.”

In the long term, though, there is much uncertainty on the rupee front. If the Indian fiscal situation does not improve markedly, a sharp deceleration in the rupee is a possibility.

Nomura’s Varma warns it could slide further to around Rs60 in the next calendar year: “We are expecting the rupee to depreciate further.” The fiscal situation is challenging and the government’s finances are strained. All the positive news is being discounted and there is hardly any room for appreciation.

For now, though, foreign portfolio flows offer a chance to salvage some rupee pride. The Indian Government has shown its willingness to bow to market forces and has boosted sentiment with the postponement for three years the GAAR (General Anti-Avoidance Rule), a highly-debated tax law that had irked foreign investors, fearing it would spark a spate of contentious tax issues.

The present stability in the forex market is welcome relief to importers and businesses, and some even see reason for hope. Says Sur: “I don’t think the Indian growth story is over. No doubt, the country should have done better. Part of the India story is still there. It’s just that we are not capitalising on the situation.”

What is clear, however, is that the government needs to do much more – and fast. If India is in an economic morass, there is no better way to get the gravy train going than to fire the engine of reform once again.