Currency comfort

But there is no room for complacency

It certainly appears that taper turbulence is far from over. While the decision to begin the $10 billion per month reduction in December was met with relative equanimity by the markets, the United States Federal Reserve's announcement that it would reduce its asset purchases by a further $10 billion a month has evoked a completely different reaction. While emerging market jitters began last week with sharp falls in the Argentinian peso and the Turkish lira, the Fed's announcement has clearly spread the impact wider, with the South African rand and the Brazilian real also moving quite sharply. Strikingly, while the Indian rupee was amongst the hardest-hit currencies when the idea of a taper first emerged last May, it has been amongst the most stable this time around. This should provide enormous comfort to both policymakers and investors, who had to deal with the extreme pressure on the currency then. What caused this sharp turnaround and is it here to stay?

One doesn't have to look too far to see what made the difference. In May, the economy's current account deficit was coming off its worst year ever by far; the deficit stood at 4.8 per cent of gross domestic product during 2012-13. Thus, the daily demand for dollars far outstripped the decreasing and more volatile inflows that the taper announcement engendered. Persistently high demand and a falling and uncertain supply are the recipe for rapid currency depreciation. While many measures were taken by the Reserve Bank of India and the government to deal with the situation, three factors seem to have contributed to the sharp decline in the current account deficit that is now visible. The restrictions on gold imports, though they may have diverted it to unofficial channels, have clearly helped to reduce the deficit. The steep fall in the rupee has fairly quickly resulted in a pickup in exports. And the sluggish growth and investment situation has resulted in a sharp drop-off in imports. Overall, by both design and circumstance, the vulnerability to the currency caused by the narrowing of the current account deficit has declined significantly and this is being reflected in the rupee's comparative stability.

However, it must be emphasised that these developments do not guarantee permanent protection to the rupee. While the ongoing US recovery will keep export prospects bright, high inflation and the depreciation in currencies of competing exporters will quickly erode the rupee's competitive advantage. Continuing sluggishness in growth could lead to fiscal deterioration and, consequently, a sovereign ratings downgrade. The latter, in particular, would exert intense pressure on the rupee. Most importantly, the bottlenecks that have stymied iron ore and coal mining, which impose a huge burden on the current account, are not visibly being addressed. All this suggests that the rupee, notwithstanding its recent display of stability, is still vulnerable and, as the taper plays out, one or more of these factors could trigger yet another bout of rapid depreciation. There is, thus, no room for complacency in this regard. Both this and the successor government have to place high priority on dealing with the fundamental sources of vulnerability.