People's Democracy

What Ails The Rupee?

C P Chandrasekhar

THE sharp depreciation of the rupee that has taken its value to more than Rs 50-to-a-dollar has refocused attention on post-crisis developments on India�s external front. Underlying that fall are developments that can be directly attributed to the global crisis. One of these is the widening of the current account deficit on India�s balance of payments from 1.5 per cent of GDP in 2008-09 to 3.8 per cent of GDP during April-September 2009. This is a remarkable
development that has not drawn much attention.

The obvious reason for this is that while export growth is slowing, imports have maintained their pace. Merchandise trade data available till December 2008 indicate that India�s aggregate merchandise exports have declined in each of the three months starting October 2008. As a result, over the first nine months (April-December) of this financial year (2008-09) exports at $130.9 billion registered a 16.3 per cent rate of growth which was significantly lower than the 23.2 per cent recorded during the corresponding period of a year ago.

Merchandise imports on the other hand recorded a higher growth of 30.8 per cent during April to December 2008 as compared with the 27.6 per cent of a year ago, because India was still affected by the burden of higher oil prices during that period. Imports of petroleum, oil and lubricants rose by 43.3 per cent during these months, as compared with 24.0 per cent in the previous year. In the event, the trade deficit rose by 58.5 per cent during April-December 2008 to $93.5 billion, from $59.0 billion during April-December 2007. There is reason to believe that this trend has only grown stronger during the current, fourth quarter of the financial year. Thus, the rupee�s weakness is partly due to the direct trade effects of the global recession.

While there is a substantial element of truth in this judgement, its importance as an explanation of the rupee�s performance should not be exaggerated for two reasons. First, oil prices have fallen further since December and would have therefore moderated import growth. Thus, merchandise import growth decelerated sharply from 24.3 to 8.8 per cent during the month of December 2008 when compared with December 2007, mainly due to a decline in oil imports. If this trend had continued the trade deficit across the year as a whole would have widened by a smaller margin than it did during the first nine months. Second, the evidence available for the first six months of 2008-09 suggest that the effect of the recession on India�s services exports have been operative with a significant lag, allowing for services incomes to neutralise part of the widening trade deficit and moderating the increase in the current account deficit. Thus, net services incomes on the current account of India�s balance of payments, which rose from $14 billion to $18 billion between April-September 2006 and April-September 2007, registered a further rise to $22.9 billion during April-September 2008. Similarly, private transfers (largely remittances) rose from $12.7 billion to $17.5 billion and $25.7 billion. As a result of these developments, while the trade deficit during April-September 2008 was $26 billion higher than a year ago, the current account deficit had only widened by $11.4 billion.

The lag in the effects of the crisis on net services incomes may be due to the fact that contracts in certain areas such as software and BPO services are signed for long periods such as two to three years. The effect of the crisis would be on the renewal of contracts and the signing of new contracts. Since recent years have been characterised by persistently higher rates of increase in revenues, even if there is a shortfall in renewals or new agreements, the impact on aggregate revenues would initially be proportionately low because of the weight of legacy contracts in the total. This could mean that when the data for the year as a whole becomes available the slowdown may be greater than suggested by the April-September figures. The lag is likely to be even greater in the case of remittances because even if workers are losing jobs and returning they would return with whatever accumulated savings they have, and this windfall effect may more than make up for the fall in the value of ongoing remittances because of lower overseas employment.

Overall, therefore, while a widening current account deficit would have a role in explaining the depreciation of the rupee, the sharp fall in the currency�s value must also be due to factors reflected in the capital account. This should not be surprising given the extremely important role that capital flows have come to play in India�s balance of payments. This disproportionate dependence on capital flows, which was substantially in the form of portfolio capital, is substantially a recent development. Foreign investment flows rose sharply from $4.9 billion in 1995-96 to $29.2 billion in 2006-07 and then more than doubled to $61.8 billion in 2007-08. This increase would not have been possible without the relaxation of sectoral ceilings on foreign shareholding and the substantial liberalisation of rules governing investments and repatriation of profits and capital from India. But liberalisation began rather early in the 1990s, whereas the expansion of foreign investment flows occurred much later. Thus, till 2002-03, the maximum level of net foreign investment inflow reached was $8.2 billion in 2001-02. This rose to $15.7 billion in 2003-04, partly encouraged by tax concessions offered to foreign investors in that year. After that India was discovered by foreign investors and was more the target of a capital investment surge rather than an attractor of such flows.

What is disconcerting, however, is the 111 per cent surge in capital flows to India during the financial year 2007-08, from $29.2 billion in 2006-07 to $61.8 billion in 2007-08. This was very different from the experience in Asian emerging markets as a group. The Institute of International Finance estimates that net direct and portfolio equity investment into Asian emerging markets (China, India, Indonesia, Malaysia, Philippines, South Korea and Thailand) fell from $122.6 billion in 2006 to $112.9 billion in 2007 and an estimated $57.9 billion in 2008. This implied that private foreign investors in equity were pulling out of emerging Asia as a group at a time when investments in India were rising sharply. India was serving as a hedge when uncertainties were engulfing markets elsewhere in Asia and the world. This increased the possibility that if any development within or outside India warranted pulling out of that country, the exit can be as strong as the inflow of foreign capital.

The crisis has indeed resulted in a sharp outflow of capital, especially capital brought into the stock market by foreign institutional investors. Needing cash to meet commitments and cover losses at home, these FIIs are selling out in Indian markets and repatriating capital abroad. Thus, over the year ending January 2009, the Reserve Bank of India estimates that the net outflow of FII capital amounted to $23.7 billion. This is indeed large when seen in relation to the estimate made by the RBI that the total stock of inward investment in equity securities stock stood at 103.8 billion at the end of December 2007. That stock had fallen to $80 billion by the end of September 2008.

However, even here the decline has been moderated by the persistence of what are defined as foreign direct investment flows. Net foreign direct investment which rose from $4.3 billion in 2003-04 to $34.4 billion in 2007-08, remained high at $27.43 billion during April-January 2008-09. But for this inflow, the impact of the exodus of portfolio capital on India�s reserves position would have been far more adverse. India�s foreign exchange reserves, which stood at $292.7 billion at the beginning of February 2008 fell to $248.6 billion at the end of January 2009. This is a significant fall, but the volume of reserves still remains high, amounting to around 9 months worth of imports. This fall does explain the weakness of the rupee, but still leaves the recent sharp decline of the rupee a bit of a puzzle.

Perhaps the resolution to that puzzle lies in the other component of capital flows into India, debt. For a few years now Indian corporations had been engaged in a version of the carry trade, borrowing money in foreign exchange from the international markets where interest rates were lower and making investments in India (besides financing investments abroad). Net external borrowing by India rose from $24.5 billion in 2006-07 to $41.9 billion in 2007-08, because of an increase in net medium and long term borrowing from $16.1 billion to $22.6 billion and of short term borrowing from $6.6 billion to $17.2 billion. The stock of India�s liabilities in the form of debt securities, trade credits and loans has risen from $105.1 billion at the end of June 2006 to $175.6 billion at the end of September2008. This huge expansion means that the demand for foreign exchange to meet interest and amortization payment commitments would be large in the coming months, when the exodus of foreign capital may continue and even intensify. This could sharply reduce the Reserve Bank�s reserves as well as tighten the foreign exchange market. That expectation may be resulting in a situation where those with commitments due are buying up foreign exchange and speculators are holding on to and not repatriating back to the country foreign exchange or are transferring foreign exchange out of the country. One indicator of the last of these tendencies is the movement of foreign exchange out of the country in the form of outward remittances under the liberalised remittance scheme for resident individuals. These remittances totalled $9.6 million, $25 million and $72.8 million in the three years ending 2006-07. But they shot up to $440.5 million in 2007-08. This is possibly indicative of the speculative trends pushing down the value of the rupee.

If this is true it does not bode well for the balance of payments and the rupee. In the face of speculation even a reserve in excess of $200 billion is no insurance against a crisis.