To understand the efficacy of the policy measure, it is important to diagnose the disease properly, the symptom of which is depreciation of the currency. There are four related channels that engender currency depreciation - current account deficit (CAD), savings-investment gap, high inflation and falling productivity.
The biggest concern is, of course, the CAD, which, for the past two years has been above 4 per cent of the gross domestic product (GDP). And, contrary to popular belief it is not gold that caused high CAD. While the level of gold import is high, it actually fell last year. And a weak external sector is only a partial explanation of the malaise. The fact is, the impact of faulty policies of the past and sheer economic mismanagement has finally caught up. Dieselisation of the economy as a consequence of an ill-conceived oil subsidy and inefficiency of the power sector (causing increased demand for diesel generated captive power as supply falls woefully short of demand) resulted in oil imports going up even when the economy was slowing. Also, despite having about 10 per cent of the world's coal reserves, India's coal production has been woefully inadequate in meeting the requirement of thermal power plants (India's main source of electricity) requiring its large-scale import. Add to that, the virtual comatose state of India's mining sector induced by policy inadequacies which have resulted in a sharp fall in India's iron ore export. High CAD is, therefore, quite natural.
Another way of looking at the CAD problem is the rising gap between savings and investment. As of FY12, while India's investment rate fell by 3 per cent from its peak of 38 per cent of the GDP, the savings rate was down by a whopping 6 per cent to 30.8 per cent. This gap widened last year. While government's profligacy resulted in high levels of fiscal deficit and hence dismal levels of public savings, household savings were hit by high inflation and resultant negative real rates of interest. High inflation resulted in households saving an increasingly lower proportion of their disposable income while negative real rates caused a flight of savings away from financial savings and on to physical savings, primarily gold.
ALSO READ: Street in rupee -watch mode
Inflation is another major concern. Although the official gauge of inflation, i.e. the wholesale price index (WPI), is falling and is now below 5 per cent, it is not an appropriate measure of inflation, especially given that the retail inflation (consumer price index) is hovering close to 10 per cent. Even the GDP deflator method of calculation of inflation indicates a higher level of inflation compared to WPI. As we are all aware, the primary reason for high inflation is severe supply-side bottlenecks - caused mainly due to economic mismanagement. Since WPI is the basis for calculating the real effective exchange rate, the perceived fair value of the rupee is approximately 58/USD, which is what the RBI is targeting. However, if we consider the deflator method of calculating inflation, the fair value of the rupee is around 62/USD.
Another reason for the weakness of the rupee is falling levels of productivity in the economy. The ICOR (incremental capital-output ratio) has fallen drastically over the past couple of years, indicating a major loss of competitiveness. At over seven, it is at an abysmal level. An important reason the ICOR has nosedived is that a humungous amount of investment (approximately Rs 7 trillion worth of bank funded projects) is stuck at various levels of implementation (due to ineffective policy making), thereby making capital that much less productive.
Clearly, whatever channel of influence we look at, the overriding cause of rupee depreciation is sheer economic mismanagement. Unfortunately, the RBI is fighting a lone battle. As a result, it hasmoved away from managing the volatility of the rupee to targeting a specific level. While doing so, it is constrained by the impossible trinity (trilemma or impossible trinity says we cannot meet all the three objectives of free capital flow, fixed exchange rate and independent monetary policy). One is, therefore, not surprised by the zeal with which the RBI is targeting liquidity.
RBI's recent action reminds one of similar action taken between late 1997 and early 1998 - when the rupee plunged by about 10 per cent following the Asian crisis. Then, the RBI responded by raising rates and increasing the cash reserve ratio. However, while during both these periods, growth remained weak, India's CAD then was only 1.5 per cent of the GDP, unlike now. Also, while external debt-to-GDP has been more or less the same, what has changed is increased reliance on short-term debt. From around 5 per cent (of total external debt) then, it is now close to 25 per cent. More worryingly, short-term debt as per residual maturity is as high as 44.2 per cent of total debt and more than 60 per cent of reserves.
Clearly, there's enough and more reason the rupee should trade around 62. While that will mean short-term pain in the form of high inflation, that's the only way India can regain some competitiveness till we see real action on the policy front.
The author is a New Delhi-based independent economist https://bsmedia.business-standard.comkunalsthoughts.weebly.com