When CAD is bad, govt should let the rupee drop to 60
The shocking deterioration in the current account deficit calls for decisive action: one clear option would be to let the rupee drop where it will.
The right response to yesterday's shocker on the current account deficit (CAD)-which came in at an unexpectedly high 6.7 percent of GDP for the December 2012 quarter-should not be soothing words.
This is the time for action, and one action that was previously unthinkable should now be on the table: a sharp devaluation of the rupee in order to give exports a leg up and imports a press down.
With the rupee at Rs 54.30 to the dollar right now, a drop to Rs 60 should give the system enough of a shock to start responding to the crisis. A further cut can be contemplated depending on how the economy responds. Remember, in 1991, it took two devaluations of the rupee to wake the system up and respond to the challenge of the external crisis.
Unfortunately, the finance ministry seems to be adopting a policy of talking down the deficit. The Chief Economic Advisor, Raghuram Rajan, has said that "there is no need for knee-jerk measures," and he expects the fourth quarter CAD to be better as exports are reviving. C Rangarajan, Chairman of the PM's Economic Advisory Council, said something similar. "CAD will be better in Q4 as the trade deficit is likely to come down."
Now, nobody needs to argue with the statement that we should not panic or adopt kneejerk responses, but it is not as if the latest CAD figure is the first scary number in a long while. CAD has been deteriorating for more than two years now, and every time it has crossed another unacceptable number, we got words, no action. In fact, our actions have always reeked of panic and kneejerk reactions.
A comfortable CAD number is not more than 2.5 percent of GDP for the Indian economy, but that number was crossed long, long ago. The only policy response has been to allow more hot money flows and clampdowns on alleged import villains (more short-term debt, easier FII inflows, liberalisation of non-resident deposits, increased import duties on gold, et al). The biggest import villain - oil imports - has never been tackled.
The net result has always been the same: a further deterioration in the CAD, and a worsening of the country's external vulnerabilities.
The Reserve Bank of India, which released balance-of-payments data as at the end of December 2012, has said that the country's external debt is now $376.3 billion, and our foreign exchange reserves are enough to cover only 78.6 percent of this exposure.
Debt rose faster than reserves, but short-term debt is rising even faster. According to Business Standard, while "long-term debt stood at $284.4 billion at the end of December 2012 (a rise of 6.4 percent over March-end 2012), short-term debt rose 17.5 percent to $91.9 billion...". Since short-term debt accounted for 24.4 per cent of India's external debt, it means a quarter of our debt will fall due for repayment fairly soon - and needs constant watching and replenishing with more short-term inflows.
Our tendency to court more short-term debts as an answer to a fast-deteriorating CAD is a sign of panic and kneejerk response, not mature long-term policy action.
If CAD - which is the difference between the country's external export earnings plus inward remittances minus imports and outward remittances - has been consistently headed south, the time for incremental reform is over.
The unstable general weakness of the rupee is not helping exports, nor is it dampening imports. The system has got adjusted to this weakness, and is no longer responsive to the exchange rate as it now stands. The government wants a stable rupee in order to deal with inflation, but if CAD is to be tackled, we can't do it by holding the rupee artificially high.
As we noted before in Firstpost, the rupee should be closer to 60-70 against the US dollar in terms of its real value. SS Tarapore, former Deputy Governor of the Reserve Bank of India, wrote in Business Line newspaper, "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 earlier 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."
The time for half-measures on CAD is over. It is time for the big bang. We have to let the rupee drop significantly to allow the CAD to recover, which will, after a lag, help the economy itself rebound. The sooner we do this, the faster the economy will bounce back.
Soothing noises and the presumption that things will look up in the next quarter are not the real answers we are looking for.