The sharp fall in the rupee has given the contrarians their moment in the sun. Forecasts of Rs 57 and Rs 58 to the dollar are being taken seriously by the markets and not being consigned to the crank’s corner. The majority view, however, is that after some more wobble, the rupee will appreciate again and slip below the 50-mark. In short, there will be gain after this bout of pain, as a newspaper headline succinctly put it.
Perhaps we should give the contrarians their due this time around. Let’s not forget that continuous depreciation, not appreciation, was the norm in the nineties and this trend persisted until 2003-04. The rupee shed value, on average, every year despite a continuous improvement in the current account deficit, the latter being driven by aggressive exports of the sunrise industries like IT and pharmaceuticals. Of course, rupee depreciation itself helped the improvement in current account since it helped competitiveness.
The rise of the rupee was actually a relatively short episode that lasted between 2003-04 and 2007-08. Brics-mania was rising, “Chindia” was in fashion and these pulled in massive amounts of foreign capital. This left the economy with massive capital surpluses that appreciated the rupee despite a continuously deteriorating current account deficit. Brics-mania, incidentally, was not just a lot of hype based on the endless possibilities that favourable demographics would yield after a couple of decades. It was under-girded by rapidly improving fundamentals — the fisc was consolidating, growth was high and inflation benign.
The contrarian case is the following. Brics-mania is ebbing as China and India post limp macro and corporate data. India clearly seems headed for a bout of hard-landing on the back of policy waffle and high interest rates. Inflation remains sticky and the room to reverse the monetary gear is limited. The fiscal deficit, too, seems out of control despite repeated assurances from the government. Massive expenditure on things like food security is pending and it seems unlikely that the government can piece together a credible strategy for getting the fisc back into the genie’s bottle. The current account deficit is worsening and dwindling capital inflows mean that there simply aren’t enough dollars going around to service it. To top it all, global uncertainty is running high and the safe-haven bid for the US dollar remains strong. The result: rising pressure on the rupee to adjust this imbalance by shedding value against the dollar.
The extreme denouement of this drama would be a balance of payments crisis that could ride on two sets of “twin-deficits”. The decade of the eighties culminated in a balance of payments crisis brought on by the interplay of a rising current account deficit and a rising fiscal deficit. This spilled over to the other twin deficit — a negative current balance and a negative capital account balance. If this were to happen again, the rupee has a long way to depreciate against the dollar before it finds its feet again.
While this scenario is possible, we are not entirely sold on this forecast. For one thing, the relationship between the fiscal deficit and the current account deficit has been somewhat weak over the past decade than in the eighties. Why could this be? Macro-economics 101 tells us that the current account deficit is the sum of the private savings and investment gap and the fiscal deficit. Over the past decade, the private gap has broken the nexus between the external deficit and fiscal deficit. Between 2003-04 and 2007-08, the fiscal deficit improved continuously and yet the current account deteriorated because high growth implied a rising deficit of private savings over private investments.
Flip this argument around and you should get a sense of why a “doomsday” scenario might not hold. As growth dwindles on the back of limp private investments, the savings-investment deficit is likely to compress and keep the current account deficit under control. Thus, even with a worsening fisc, we might not get a yawning current account gap. That could prevent the rupee from falling too sharply. To fall back on the jargon used by economists, the current account could act as an “automatic stabiliser”.
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That said, we believe that instead of an appreciation bias, the rupee is likely to have a deprecation bias over the next few months. Thus, levels of 54 or even 55 to the dollar cannot be ruled out. What can certainly be ruled out is a quick move back to the 47-48 range. Also, even if the rupee were to somehow consolidate at current levels, we might be stuck in a completely new trading range against the dollar that involves much weaker levels for the rupee than in the past.
In the very near term, there is some scope for consolidation. For one thing, the Reserve Bank of India seems to be getting quite antsy about conditions in the currency market. If it sees another round of depreciation pressure, it might take more aggressive measures to curb it. One option that it could exercise is to supply the dollar-hungry oil companies from foreign exchange reserves and take the pressure off the markets. Besides, the rupee seems a trifle oversold and there could just be a technical pull-back that could lend it temporary stability. However, any significant reversal could come only if capital flows come back. If the situation in Europe worsens as it threatens to, that’s unlikely to happen in a hurry. However, if there is indeed a comprehensive resolution going forward (we remain eternally hopeful) to Europe’s impasse or if the US Fed does another round of liquidity easing, we might see a turn in the exchange rate that might just sustain.
The authors are with HDFC Bank. These views are personal