By R Jagannathan
If the Reserve Bank Governor made a bigger song-and-dance about the current account deficit (CAD) than inflation in his monetary policy of 29 January, there is a reason for it.
The rupee is simply overvalued, given current inflation rate differentials between India and its main trading partners. And in a scenario where exports have been tumbling for almost every month of this fiscal year, the rupee should be headed down, not up. The currency is, in fact, acting against its fundamentals, driven largely by high capital inflows.
India’s latest consumer price index (CPI) inflation is 10.56 percent for December 2012. Compare that with the US’s 1.7 percent, the euro area’s 2.2 percent, China’s 2.5 percent, Japan’s -0.2 percent, and Britain’s 2.7 percent.
The difference between India’s CPI rate and that of its major trading partners is thus 8-9 percent – and this has been so for the last couple of years now.
On the other hand, India’s ability to earn more dollars has been worsening, with December reporting the eight successive month of a decline in exports. The trade deficit (which is CAD minus invisible earnings, including remittances) in April-December has hit a new high of $146.2 billion, even higher than last year’s 137.3 billion, when export growth was much better.
The RBI, in its policy statement, has indicated that things will get worse in the third quarter. It noted: “On top of the large trade deficit, the slowdown in net exports of services and larger outflows of investment income payments is expected to widen the current account deficit (CAD) further in Q3, beyond the level of 5.4 percent of GDP recorded in Q2 of 2012-13.”
Given this double-jeopardy, the rupee’s current perch of Rs 53.25 (or thereabouts) against the US dollar is simply unsustainable unless capital flows continue to keep staying high.
So where should the currency really be? The obvious answer should be much lower.
According to SS Tarapore, former Deputy Governor of the Reserve Bank of India, the rupee should be closer to 70 against the US dollar. He wrote recently in BusinessLine: “With the inflation rate persistently above that in the major industrial countries, the rupee is clearly overvalued. Adjusting for inflation rate differentials, the present nominal dollar-rupee rate of around $1 = Rs 54 should be closer to $1 = Rs 70. But our macho spirits want an appreciation of the rupee which goes against fundamentals.”
Rajeev Malik of CLSA, writing today in Firstpost, had this to say: “The worsening CAD is partly signalling that the rupee is overvalued. But the RBI and everyone else are missing that clue. That is because policymakers further open up the tap to attract more volatile, risk-driven foreign capital to finance a worsening CAD. Indian policymakers are making a simple mistake to think that as long as capital inflows finance a worsening CAD, the rupee is appropriately valued. This is incorrect. India’s high inflation differential will contribute towards making the rupee overvalued even if capital inflows are adequate to finance a bigger CAD.”
But as Tarapore notes, “A CAD which can be easily financed in one period can become difficult to manage in another. The exodus of capital can be very sudden and large when the international community loses confidence in India.”
The other point to underscore is that India’s CAD is worsening at a time of slow growth. If the idea is to raise the growth rate with lower interest rates and other stimulus measures, the CAD will worsen, notes Malik.
The inescapable conclusion: the rupee cannot defy gravity indefinitely against the odds. So don’t count on the rupee staying under 55 to the dollar for long. Even last year’s low of Rs 57-and-odd can be breached if global confidence in India suddenly slips.
So keep your fingers crossed. And if you are the betting type, you should be betting against the rupee.