Rupee’s dancing to more tunes this year

The Indian currency has been facing some selling pressure for the last 4-5 weeks, chiefly on the back of rising crude price. The rupee fell against the U.S. dollar by a little over 2.5% in April, and 4.3% since the beginning of the year, making it the worst-performing Asian currency.

Compared to the position as of end-March 2017, the rupee is now about 3% weaker vis-a-vis the U.S. dollar. RBI is reportedly intervening in the market to cushion the rupee’s fall.

After nearly four years of subdued and benign oil prices and the consequent improvement in the country’s terms of trade, India once again faces its age-old vulnerability to high cost of oil import.

U.S. dollar recovering

And this has come at a time when the U.S. dollar seems to be on a cyclical recovery path against other major currencies on the relative strength of the U.S. economy. On all such occasions in the past, the rupee as well as the capital account of the country’s Balance of Payments came under pressure.

But this repeat of history now has other elements that compound the overall external sector vulnerability: overvalued rupee, rising current account deficit, sudden ebb in capital inflows and certain developments in the domestic political economy policy front.

Going by its 36-country trade-weighted real exchange rate index, the rupee is currently overvalued by more than 17% relative to 2005. The movement of this index over the last few years provides some interesting insights: the real effective exchange rate of the rupee has gone up by about 4.73% since 2015-16, but it remained flat in 2017-18, although the nominal effective exchange rate of the U.S. dollar fell by about 9% during that period.

The table alongside illustrates this point. This highlights the structurally higher inflation in India not just in relation to the U.S., but vis-a-vis all its major trading partners and competitors as well.

RBI expects CPI inflation to lie between 4.4%-5.1% during the current fiscal year, with higher inflation expected in the first half. For the purpose of this estimate, RBI has assumed an average oil price of $68 per barrel. If global prices turn out to be higher than this, then the inflation will be higher. With the benchmark Brent having already touched a high of $75 per barrel, the possibility of inflation crossing 5% in the coming months is high.

The moot point here is that the inflation differential between India and most of the major trading partner countries is close to 3%, which explains the sustained real appreciation of the rupee.

In the past, real exchange rate appreciation would lead to abrupt and large changes in the nominal exchange rate of the rupee against the U.S. dollar, often triggered by domestic macro/political and global economic developments, the latest example being the burst of sharp depreciation of the rupee in August-September, 2013 caused by the so-called ‘taper tantrum’ announcement by the Federal Reserve to curtail its quantitative easing programme.

Rising wages

The significant real appreciation of the rupee calls for a deeper probe as regards its causes and consequences for trade competitiveness. First, labour productivity has increased at an average rate of 6.3% annually since 2005, which is way higher than the annual average of 3.3% recorded in the previous 12 years.

We need further research to determine if the consequent wage rise led to higher inflation, real appreciation and increase in current account deficit within the theoretical framework of Balassa-Samuelson Effect.

As regards the consequence of the real appreciation of the rupee, it needs to be ascertained if any increase in factor productivity in the tradeable sector has cushioned its adverse impact on the competitiveness of the country’s goods and services. This is crucial for the purpose of guiding exchange rate policies of RBI and the government. India’s current account deficit increased to 1.9% of GDP in April-December 2017 from 0.7% in the corresponding period of 2016-17 on the back of about 44% widening of the trade deficit during this period.

While the country’s imports relative to its GDP is now much lower than the peak level reached in 2012-13, the performance of exports continues to be lacklustre. In the financial year 2013-14, exports were 17.2% of GDP and by the financial year 2016-17, the ratio fell to 12.4% of GDP.

In the traditional areas of exports, such as garments and textiles, where India was second only to China, the country now occupies third position in textiles and fifth position in garments.

The case of garments exports is interesting as in 2000 the share of clothing exports as a percentage of total global clothing exports of Bangladesh, Vietnam and India was 2.6%, 0.9% and 3% respectively. By 2016, while India’s share of global clothing exports has increased marginally to 4%, Bangladesh has improved its share to 6.4% and Vietnam’s share is a stellar 5.5%.

This is a pointer to India’s inability to gain market share in a global business which is consolidating among the top ten countries. Despite the claims of ‘Make in India’, India does not yet figure among the top ten exporters of manufactured goods. China now exports manufactured goods worth $2 trillion (almost equal to India’s GDP) and its share of global exports of manufactured goods increased from 4.7% in 2000 to 17.9% in 2016.

The silver lining in India’s current account in the past has been the export of services export. Indian IT services companies, which followed a low-cost global delivery model with success in the past, have not succeeded so far in graduating to the new world of artificial intelligence, machine learning and robotics.

In the first half of the financial year 2017-18, growth in IT services exports compared to the corresponding period in 2016-17, was a meagre 2.3%. Growing trade protectionism in the West will certainly slow down the growth of exports of IT and IT-enabled services, unless Indian companies move up the value chain. Tourism and transfers from migrant workers in the Gulf have remained robust.

India’s gold import, which was $56 billion in 2011-12, declined 52% to $27 billion in 2016-17. However, a rising trend of gold import is now being seen, with the import in 2017 at 855 tonnes — a 67% rise over the previous year,

The other worrisome trend is the rapid growth in imports of electronic goods, which was $3.4 billion in 2011-12 and $42 billion in 2016-17 — a massive 12-fold increase in five years.

There is a distinct possibility that imports of electronic imports, mostly from China, will surpass oil imports in the near future.

The rising trend of import of gold and white goods could very well be a manifestation of the rupee’s overvaluation.

The FDI and portfolio flows in the first nine months of 2017-18 remained robust. But, a decline in portfolios flows is taking place now, as evidenced by an outflow of $2 billion in April. Foreign exchange reserves at $424 billion, with another $22 billion in forward purchase, look formidable to be able to quell any market volatility. But, as before, the leeway to spend the reserves is not unlimited and decline in foreign currency assets is already happening. Further, applying IMF’s metric of reserves adequacy, the safe level of foreign exchange reserves for India turns out to be $496 billion.

Disagreements with IMF?

Curiously, India’s annual Article IV consultation with the IMF staff, which usually takes place in February, has not yet happened this year. As per its office in India, the earliest it is going to happen is in July, 2018. One wonders if the delay is due to any disagreement between Indian authorities and IMF staff on macro issues.

Typically, in the last ten years, sharp currency movements have happened in years of political transition. Macroeconomic populism has already led to fiscal slippage; and uncertainty around the extent of RBI’s commitment to an inflation-targeting regime amid rising inflationary pressures and external sector vulnerability will make 2018-19 a challenging year for Indian policymakers. Higher oil prices mean tough choices, especially on the fiscal front. In fact, there are no easy options left on any of the major macroeconomic policy front in the lead-up to the next general elections.

(Sivaprakasam Sivakumar is MD, Argonaut Global Capital, U.S. and Himadri Bhattacharya is Senior Advisor, RisKontroller Global)