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Weakening rupee bodes ill for Indian economy

The rupee has come under renewed pressure, weakening to a three-month low of 51.6 to a dollar before edging up. Analysts say dollar is unlikely to slip below Rs50 anytime soon.

The Indian unit is reeling under the cumulative effect of foreign investor’s disappointment over the budget, adverse global news and a weakening external account. This has serious implications for management of inflation, servicing of corporate debt in foreign currencies and, above all, monetary policy.

The Budget has disappointed and dismayed foreign investors on more than one counts. The General Anti-Avoidance Rules (GAAR) have aroused fears of taxes being imposed on transactions done in the past and new investment instruments being drawn into the tax net. Most foreign investors, like Indian observers, nurture serious doubts about the finance minister’s ability to meet his fiscal targets and worry what an overshoot could mean for interest rates and inflation. Few believe that he would be able to keep subsidies below the two per cent of GDP cap that he has announced. The fracas over the Railway Budget has certainly lowered the government’s credibility.

The global situation remains murky. Greece’s problems may have been sorted out at least temporarily but that has been replaced quickly by growing concerns about Portugal and Spain’s fiscal positions. Besides, whether or not the euro endures, Europe is facing a long period of economic stagnation or worse. China’s dimming growth prospects and overheated housing market have added to the list of woes.The rise in global uncertainty has bred a risk aversion in global investors and assets in countries seen as risky have seen selling pressure. In India’s case, concerns over its domestic problems have added to the pressure from global factors.

The balance of payments (BoP) data for December 2011 quarter has revealed several worrying trends. At 4.3 per cent of the GDP, the current account deficit (CAD or the gap between India’s export of goods and services including remittances and the foreign exchange outgo on imports and other current obligations) for that quarter is highest in the last 40 years. Although gold imports have levelled off a bit in March, the financial year could end with a current account deficit of a little over four per cent. Why is all this important? First, the deterioration in India’s external accounts is worrying in itself, indicating excess demand in the economy. Combined with persisting concerns about the global financial system, and likely tepid capital flows into India, this increases India’s external payment vulnerabilities.

More importantly, this perception is likely to keep the rupee weak, creating problems for managing inflation. A weak rupee, combined with rising prices of crude and some selected industrial commodities, could push up inflation in the coming months. In addition, the burden of external debt payments (interest and principal) will increase, aggravating pressures on corporate balance sheets, which are already stressed in the slowing growth and high interest rate environment. A worsening rupee lowers returns for foreign investors in home currencies, adding another disincentive in an investment climate already fraught with uncertainty.

The worst effect of the worsening external environment will be on the conduct of monetary policy. Rise in inflationary pressure, vulnerability on the external account and fears of further weakening of the rupee, will further constrain RBI’s options in easing monetary policy. Industry and markets, which have been expecting a significant reduction in interest costs, may be in for a disappointment. Investment climate will become gloomier and industrial recovery will take longer.

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