Jun 2, 2012

The Falling Rupee & RBI's Losing Battle

How much is the rupee going to depreciate ? That's a question which the expatriate community keeps asking to every Tom Dick & Harry. The intention is to lock in on the most favorable exchange rate (i.e, highest depreciation ). Similarly when I visited India recently, some of the discussions often veered towards concerns on depreciating rupee as it is increasing the fuel cost.  Now, predicting the level is like a lottery. I'm not going to do that. The level, hinges on a lot of policy decisions by Govt, RBI & even the European Central Bank. Instead I want to write on a set of common misconceptions prevalent in Indian media about this phenomenon

1) Why cannot RBI sell dollars & pop up rupee ? 

RBI cannot and should not try intervening in forex market beyond a level. The volume of INR currency market is supposed to be about $40 - $50 billion a day . Now, to seriously make an impact on the exchange rate, RBI will have to release about $10 billion a day ( i.e, bare minimum one fourth ). With the present level of foreign exchange reserves ($290 billion ), this activity can go only for a month at the max. And if RBI tries doing that, rupee will be prone to speculative attacks of this nature

2) So, who is supposed to address the problem ? RBI or Govt ? 

Govt. This depreciation is due to fiscal profligacy ( i.e, in simple terms, govt is spending more than it earns ). This was possible till now because capital flows to India were strong. With the advent of Eurozone crisis ( and many other internal factors ), these inflows have dried up.

Rupee, in one sense , can be visualized as the guarantee (legally it is a promissory note ) given by Govt of India.  If such a guarantee is issued by an entity whose expenses are greater than revenue, the value of guarantee will go down. This in-short explains the depreciation of rupee without getting into complicated economic parameters like Fiscal deficit & current account deficit.

3) What should the govt do / rather should have done ?

Depreciating currency is a cheap trick used by governments worldwide to promote export competitiveness. India too has fallen prey to this. When economy is doing well, government should do enough things to bring down the real 'cost of doing business' and 'cost of living' . i.e, power , modes of transport, infrastructure, food etc. Doing these things would have been relatively easy when economy was doing well. Now, a depreciating rupee forces govt to reign in their expenses. Doing enough infrastructure investments is difficult in such times. But there is no other option.  Certain reforms which are targeted towards these areas ( transport, food prices, power ) should be undertaken in high priority.

4) Should the fuel prices be deregulated in India ? 

This is a painful decision point. But ultimately, yes. these have to be deregulated. You cannot simply sell something at a lower price than what you procure. However, thats a long term goal .

The present manner in which prices are determined has no big logic. Hence, everyone is at a loss to explain a high/low price. I would say, its best to arrive at a index based pricing system. A formula which involves Global crude indices, rupee exchange rate etc.

In short term, taxing private diesel driven vehicles should be a priority. Otherwise we are just subsidizing the rich at the cost of poor.