Thursday, August 29, 2013

Crumbling Rupee, the reasons and the solution

I think the value (or lack of) the currency exchange rate has reached the common man. As a Non Resident Indian, visiting India, its surprising to find taxi and autorickshaw drivers complaining about the falling rupee. This has caused a lot of debate in social media and others, and these are my thoughts 

Do note: This blog is my personal view, and doesn't reflect the view of my employers. 

The main reason for falling rupee was that India Imports more than it Exports. Though the rupee was stable, since this trade deficit was being financed by foreign portfolio flows investing in Indian equities and debt, and suddenly with signs of US economy improving, they are moving their money out. 

Looking at numbers: Imports $40bn a month, Exports $32bn a month (goods + services) 
Hence now India needs to buy this $8bn a month (add to the selling by foreigners) at the prevailing price in the market, and due to laws of supply and demand, rupee is falling.

India is particularly vulnerable as it runs a twin deficit. A trade deficit (imports more than exports) and a fiscal deficit (government spends more than it collects via taxation). 

What caused the sudden spiral? 
The straw which broke the camels back, was the US Federal Reserve announcing tapering the pace of 'Quantitative Easing' (In simple language printing money to buy back their debt) 
Though the intention was to keep interest rates low to boost growth in US, (companies could borrow to invest, households could borrow to buy houses and consumer goods) the side effect was many investors chose to invest overseas for higher yield in Emerging Markets, and India was one of them. 
Now as US yields rise, India doesnt look as attractive anymore. 

Why is India more vulnerable than other Emerging Market Countries? 
Simply put, India imports more than it exports. The balance was being financed by foreigners buying Indian stocks, bonds, and Indian companies borrowing offshore, plus some remittances by NRIs. 
Looking at some numbers: 
Imports: USD 40bn a month, of which crude oil is $15bn, Gold and Silver is $5bn, Coal and Iron Ore is $2bn. Rest is flat screen TVs, iPhones, iPads and what not.
Exports: Goods worth $25bn, and Services (software and BPO)  $7bn. 
Thus India has a trade deficit of USD 8bn a month. 

Shouldn't weaker Rupee imports fall and exports rise? Now with India's imports they have been fairly inelastic, (falling rupee hasnt seen the volumes of imports falling) which is mainly due to 
  1. due to subsidies on oil products (diesel, kerosene, and LPG) consumers don't feel the pinch of the rising prices directly. The deficit is borne by the taxpayers indirectly. 
  2. Indians have a cultural affinity for Gold, when rupee falls, Gold looks more like a safe haven, though it behaves like a speculative asset. (i.e. when price rises, demand also rises) 
  3. India has one of the largest reserves of coal and iron ore. But due to the corruption in handing out mining licenses, there have been lot of court cases under RTI. Hence the supreme court has put a blanket ban on mining coal and iron ore. This has caused India to move from Net Exporter to Net importer of coal and iron ore. 

Exports too have been inelastic. i.e. volumes havent gone up, despite falling rupee making it cheaper 
  1. Constraints of manpower (bad labour laws) and electric power supply make scaling up in manufacturing difficult. 
  2. Textile industry which was a pollutant has been shut down and mostly relocated to Bangladesh and Vietnam. 
  3. while US and Europe seem to have come out of recession, their growth isn't so high that their demand for Indian exports rises.

Why don't we see Foreign Direct Investment - given India's size and consumer demand?
India's rules and red tape have made it quiet unattractive. 
e.g. after all approvals, Vendanta and Posco's aluminium and bauxite investment plans were vetoed by tribal families (~300 families). These investments were worth billions of USD. 
There is no clarity on FDI in retail, or in many other sectors. 
Post the Vodafone case, the GAAR rule on taxation and retrospective taxation makes it difficult for people to want to invest in India.
Also note, US economy is 8-9 times the size of the Indian Economy. Hence when US was growing sub 1% and India more than 9% investing in India looked attractive. 

When US economy is expected to grow at 2.5-3.0% and Indian economy at 4.5% India doesnt seem as attractive (due to low base) 

Despite these reasons why the sudden large moves? 
Basically once it becomes a self fulfilling prophecy we can see large scale capital flight. 
Exporters will not remit money back to India and keep money offshore. 
Importers will over-invoice and transfer money offshore.
NRIs might choose to wait before remitting (since they feel will get it cheaper a month later)

Some portfolio investors seeing the crashing rupee and the stock market would panic and sell their Indian investments. 
This is more due to crisis of confidence, and this is where the Finance Ministry and the Reserve Bank of India can step in to curb this crisis of confidence. 
But in the longer run India should address the fault lines. 

Even other currencies are falling (South African Rand, Brazilian Real, Indonesian Rupiah, Turkish Lira) 
These countries too have a large current account deficit. At the other end of the spectrum are South Korean Won and Taiwan Dollar, which have done well, as they are net exporters, and stand to benefit from US and Europe growth picking up.

Why can't RBI do anything? 

RBI has a trilemma, to maintain stability in inflation, growth and currency (or current account) 
It cant have all 3 together, and one has to be sacrificed. 
The only tools it has is interest rates and money supply, and given the problems are fiscal, RBI's monetary policy cant do much. 
(they have hiked rates to protect the currency, but that makes growth come lower)
Given the problem is fiscal and political, the solution too should come from politicians and not RBI.

What has been done to address the fall?
RBI has hiked short term interest rates by 3%, and raised taxes on Gold imports, curbed speculation by banks, and limited amount of money that can be remitted offshore by locals. 
Finance Ministry has announced duties on imports and curbs on getting in Flat Screen TVs.
They have also let Oil Marketing Companies borrow USD directly from RBI via a swap line. (which can be repaid later, IF rupee becomes stronger)

I think these measures are short term at best.

In the longer run more structural issues need to be addressed.

Reviving stalled power projects, reform of labor laws would go some distance in improving productivity and raising our goods exports. 
Tightening the belt on fiscal spending, should keep inflation in check and regain investors confidence to buy Indian assets when they are cheap. 

For more see the video with Arun Shourie (ex minister for disinvestment in the NDA government) and Ruchir Sharma (of Morgan Stanley Investment Management) discuss the "Rise and Fall of Indian Economy" with Prannoy Roy of NDTV.

What can an ordinary citizen do? 
There isn't much at an individual level. Each one buying swadeshi goods doesn't solve the bigger problem. (There is no Swadeshi Oil)
Voting for a party which is willing to take short term pain for longer term development might be the answer. (Don't know which party though)

After US mortgage crisis (leveraged households), European sovereign debt crisis (leveraged peripheral European nations), we might see the beginning of the Asian Financial Crisis (leveraged corporates) and this might be as bad as the Asian crisis in 1997-98.

Hence we might see things get worse before they get better. 

I do believe India has enough low hanging fruit, and the right political will should see growth rising again. 
This crisis might just force the leaders to take tougher decisions.