rupee dollar: why the rupee is likely to fall further even as exports lose competitiveness
These are all very real risks, the IMF says in its World Economic Outlook (WEO) update, containing inflation – which is expected to rise to 6.6% in advanced economies and to 9, 5% in developing countries this year – being the priority. India is in the second category. But its inflation rate is hovering around 7% with an easing bias, while the United States faces inflation above 9%. This makes their monetary policies diverge, although energy inflation and imported food have triggered this phase of inflation in the world.
India’s interest rate tightening cycle is shallower than that of the United States, mainly due to different assessments of underlying inflation, which filters food and fuel prices, and the fact that the Reserve Bank of India (RBI) started at a much higher policy rate than the US Federal Reserve. RBI believes it has a long way to reach the historic interest rate differential with the Fed.
For now, capital is flowing out of India due to interest rate convergence, depleting its foreign exchange reserves, with RBI intervening in the currency market for an orderly descent of the rupee. There has been a recent reversal in capital flows since the rupiah rose above 80 to the dollar on signs of slowing rate action by the Fed. India mainly attracts capital in the form of equities and the growth outlook for the economy is easing some pressure on the rupee. Foreign direct investment and remittances also help stabilize the currency.
RBI’s stated goal of avoiding currency volatility stems from India’s reliance on energy and fertilizer imports. It tapped into foreign exchange reserves to support the rupee so that the fuel import bill did not inflate. Following trade fundamentals, the rupiah has further declines in store even as exports lose competitiveness against economies whose currencies are declining faster.
The other policy option would be for the RBI to raise interest rates faster to eradicate the second-order effects of soaring energy prices while allowing the rupee to find its own level. That would be the IMF’s prescription, and accelerated monetary tightening is the reason it cites for lowering India’s growth forecast.
Separately, government intervention in energy and food markets tends to make the prices paid by consumers rigid. These measures support domestic demand during periods of high energy and commodity prices. They also open the trade deficit, which favors the devaluation of the rupee. Fiscal support for domestic consumer demand is provided through tax cuts, expanded subsidies and asking producers to absorb some of the pain. All of these have an impact on the budget deficit as well as the industries involved.
In an assessment of the sectoral impact of the depreciation of the rupee, the rating agency
notes that the fertilizer industry will be protected against rising input costs by a larger subsidy, the under-recoveries of oil marketing companies will increase, the indebtedness of electricity distribution companies will increase due to imported coal , future solar energy projects will face higher unit costs, and town gas distributors will see their operating profit margins squeeze.
Supply-side responses to control energy and food prices should ideally target vulnerable segments without distorting markets. A tight fiscal stance after a pandemic-induced expansion would require a combination of raising tax revenue and streamlining spending. Public debt is well above prudent levels as interest rates tighten. This could have implications for private capital spending.
There is a limit to the drawdown on foreign exchange reserves set by the number of months of imports they must cover. Unless the external environment recovers dramatically in the foreseeable future, the RBI may have to recalibrate the pace of its interest rate hikes and the degree of its intervention in the foreign exchange market. Indian policymakers may have to reassess the growth they are willing to sacrifice in the fight against inflation.
Supply Chain Response
Then there are exports, which are much more market-sensitive. Exports slowed sequentially, driven by declines in machinery, medicine and textiles. These slow players have been affected by supply chain disruptions, monetary tightening and the European conflict. Refined oil is vulnerable to further trade fragmentation. Information technology (IT) depends mainly on the US and EU, which are plagued by stagflation. These could do with the help of a falling rupee.
Asian economies, with the notable exception of India, have experienced long periods of low inflation due to their current account surpluses. Becoming a net exporter requires improvements in labor productivity that can sustain rising consumption. The common path for most of these export-oriented economies has been currency depreciation.