India is screwed, no matter what RBI does on rupee

The Reserve Bank of India (RBI) finally threw in the towel today. Over the past several days it had been selling dollars in the foreign exchange market and had thus managed to hold back the rupee to under 60 to a dollar.

The RBI tried halting the fall of the rupee by selling dollars today as well. A report on www.livemint.com points out that "The Indian central bank(i.e. the RBI) intervened by selling the dollar at 59.98, earlier in the day, according to currency dealers, who added that a foreign bank had aided RBI by selling dollars in the market."

This helped the rupee to recover to around 59.93 to a dollar. But it soon crossed 60 to a dollar. At the end of trading today, one dollar was worth Rs 60.73.

 India is screwed, no matter what RBI does on rupee

Reuters

The question being asked is could the RBI have continued to sell dollars and help stem the fall? As on June 14, 2013, India had foreign exchange reserves of $290.66 billion. This is tenth largest in the world.

So it seems that the RBI has enough dollars that it can sell to halt the rupee's fall against the dollar. But things are not as simple as that. Indian imports during the month of May 2013, stood at $44.65 billion. This basically means that the current foreign exchange reserves are good enough to cover around six and a half months of imports ($290.66 billion of foreign exchange reserves divided by $44.65 billion of monthly exports).

This is a very low number when we compare it to other BRIC economies(i.e. Brazil, Russia and China),which have an import cover of 19 to 21 months. What does not help is the huge difference between Indian exports and imports. In May 2013, Indian exports fell by 1.1% to $24.51 billion. This meant that India had a trade deficit (or the difference between imports and exports) of more than $20 billion. The broader point is that India is not exporting enough to earn a sufficient amount of dollars to pay for its imports.

In this scenario the RBI can use only a limited portion of its foreign exchange reserves to defend the dollar. An estimate made by Bank of America- Merrill Lynch suggests that the RBI can use upto $30 billion to defend the rupee. If it chooses to do that the foreign exchange reserves will come down to around $260 billion, which would mean an import cover of around 5.8 months ($260billion divided by $44.65 billion of imports). This will be a very precarious situation and was last seen in the early 1990s, when India had just started the liberalisation programme.

This is one reason behind why the RBI cannot stop the rupee from falling beyond a point. More than that it does not make sense for any central bank (unless we are talking about the People's Bank of China) to obsess with a certain currency target against the dollar. This was the learning that came out from the South East Asian crisis of the late 1990s.

Various South East Asian currencies were pegged to the dollar. The Thai baht, was pegged to the US dollar with one dollar being equal to 25 Thai baht. The Philippines peso was pegged at 25 pesos to the dollar. The Malaysian ringgit was pegged at 2.5 ringgits per dollar and so was the Indonesian rupiah, which was pegged at 2030 rupiah to a dollar.

The central banks of these countries ensured that there currencies continued to remain pegged. In case the market suddenly had a surfeit of baht, and the baht started to lose value against the dollar, the Thai central bank started to buy baht and sell dollars. In a situation where the market had a surfeit of dollars and the baht started to appreciate against the dollar, the Thai central bank intervened and started to buy dollars and sell baht. This ensured that the value of the baht against the dollar remained fixed.

But when the South East Asian crisis started, investors started to exit these countries lock, stock and barrel. So if an investor sold out of the Thai stock exchange he was paid in Thai baht. When he had to repatriate this money abroad he needed to convert these baht to dollars. So suddenly the foreign exchange market had a surfeit of Thai baht. In the normal scheme of things, the value of the baht would have fallen against the dollar. But the baht was pegged to the dollar. So as a logical step the Thai central bank started to sell dollars and buy baht, in order to ensure that one dollar continued to be worth 25 Thai baht.

In May 1997, the finance minister of Thailand was fired. The new finance minister made a secret visit to the central bank and realised that the country had more or less run out of dollars trying to defend the dollar-baht exchange rate. The bank had run through nearly $33billion of foreign exchange reserves trying to defend the exchange rate.

On July 2, 1997, Thailand decided to stop supporting the baht and let it fall. It was estimated that the baht would fall by around 15%, but instead by the end of July it had already fallen by 20% to 30 baht a dollar. A year later the exchange rate was down to 41 baht to a dollar. And within two weeks of Thailand setting the baht free, others followed. The Philippines peso's peg with the dollar broke on July 14. The peg of the Indonesian rupiah and the Malaysian ringgit also broke the same day.

A year later the Indonesian rupiah was at 14,150 to a dollar. It had been at 2380 to a dollar. The Malaysian ringgit was at 4.1 to a dollar, down from 2.5. And Philippines peso was at 42 to a dollar against 26.3 a year earlier

That is the problem with trying to defend the exchange rate. It needs an unlimited amount of dollars, which no country in the world other than the United States (and to a certain extent China which has nearly $3.3 trillion foreign exchange reserves) has. And only the Federal Reserve of United States, the American central bank can print dollars. No other central bank can do that.

A similar situation is playing out in India right now. Foreign investors are looking to exit the country. They have sold off more than $5 billion worth of bonds since late May. They have also sold off stocks worth $1.39 billion in June, after buying stocks worth $4 billion in May. These investors are now trying to convert there rupees into dollars, and that has led to the rupee rapidly depreciating against the dollar.

The RBI tried to halt this fall by intervening in the foreign exchange market and selling dollars. But as the South East Asian experience tells us, obsessing with a certain target against the dollar is not a great idea.

So given that the RBI has got it right by not obsessing with the target of Rs 60 to a dollar. But the trouble is that a weaker rupee will have several negative consequences in the days to come (This is discussed in detail here).

First and foremost will be higher inflation as India will pay more for imported products. Oil will become expensive in rupee terms. If the government passes on the increase in price to the end consumer, then it will lead to higher prices or inflation. If it does not pass on the increase in prices to the end consumer then the government will run a higher fiscal deficit as its expenditure will go up. Fiscal deficit is the difference between what a government earns and what it spends. It will also mean that the government will have to borrow more to finance its expenditure and that in turn will mean that the high interest rate scenario will continue.

India imports a lot of coal which is used for the production of power. With the rupee losing value against the dollar the cost of importing coal will go up. Coal in India is imported typically by private power companies to produce power. The government owned Coal India Ltd, does not produce enough coal to meet the needs. The Cabinet Committee on Economic Affairs recently decided to allow private power companies to pass on the rising cost of imported coal to consumers. This again will add to inflation.

Companies which had borrowed in dollars and have not insured themselves against the fall of the rupee, will have to pay more. Economist Arvind Subramanian points out in the Business Standard that there will be "a decline in the profitability of all those enterprises that have borrowed heavily in foreign currency and have not insured themselves against a rupee decline ("unhedged borrowing")."

This cost "will manifest itself in reduced investment by these companies and hence lower aggregate growth; it will also manifest itself (eventually) in a worsened fiscal situation because the government will have to support these companies directly or the banks that have lent to them," writes Subramanian.

The broader point is that India is screwed both ways irrespective of whether RBI defends the rupee or not.

Vivek Kaul is a writer. He tweets @kaul_vivek

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Updated Date: Dec 20, 2014 19:50:17 IST