How depreciating rupee dents the already battered CAD and the fiscal deficit

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The situation is grim. It is beyond debate that a depreciating rupee dents the already battered current account deficit (CAD) and the fiscal deficit further. How? CAD first. Exporters refrain from repatriating export proceeds. Why should they when they know the dollar would earn yet more rupees if they can wait a little longer?

Second, those holding stashed funds abroad continue to hold them in perpetuity. They watch the situation in silent appreciation, as they witness the rupee sinking to new depths effortlessly. Third, repatriable yield in dollar terms of foreign investors (foreign direct investments as well as portfolio investments) diminishes, thereby dampening the investment climate in India. Fourth, foreign currency non-resident ( FCNR) deposits become less attractive for banks since the swap cost of funds soars due to a higher forward premium of the dollar.

Fifth, NRIs tend to avoid non-resident external (NRE) repatriable rupee deposits since repatriable yield in dollar terms diminishes. Sixth, hedging cost of external commercial borrowing shoots up. This further jolts India's business environment as external commercial borrowings and corresponding reverse foreign investments are often intertwined. And, finally, genuine foreign investors turn away to other stable destinations.

And now the fiscal deficit. Two of the biggest components of non-Plan expenditure are interest payment and subsidies. As a consequence of the rupee's depreciation, both these components swell. Though the share of India's sovereign external debt to total external debt was 21.7% at the end of December 2012, in absolute terms, this well exceeds $80 billion. It is axiomatic that the external debt servicing cost in terms of the rupee, due to the latter's depreciation, shoots up, putting a strain on the exchequer.

Import costs of oil and gas too shoots up, putting further strain on the fiscal health of India. Non-Plan expenditure also swells due to higher import bill towards fertiliser subsidy. So, it is clear the rupee's depreciation has a direct link with escalating non-Plan expenditure, that is, interest payment and subsidies.

The CAD crisis and fiscal crisis are, thus, inextricably linked. Add to this the all-round inflation caused due to the rupee's depreciation. The situation needs immediate correction. What can be done to stem the rupee's rot without damaging the economy further? First, the RBI should immediately enter the foreign exchange market with a two-way quotation. My suggested band would be 55 to a dollar, plus or minus 5%. In years past, RBI, Mumbai (then, Bombay), used to buy spot pound sterling and forward up to 12th month. RBI also used to sell pound sterling that was then India's intervention currency. These rates used to be quoted through the Reuters Monitor screen and the RBI was bound by these rates to any authorised dealer who approached the RBI with genuine merchant transactions.

As a sequel to such quotations, the Indian foreign exchange market used to invariably settle down and trade in the band between RBI's buying and selling rates. Somehow, a few years after the pound was displaced by the dollar as India's intervention currency, this practice was discontinued. In my view, it is worth a try again with the dollar. The market is bound to settle within this band without additional outgo of foreign exchange from India.

Let us not make fashionable statements that the rupee's rate is determined by the market. There is no market other than banks and the RBI. RBI cannot watch the situation in silence and feign ignorance. Economic theories pertaining to interest rate differentials, inflation and exchange rates do not work when India still has severe exchange control regulations in place.

There is no free convertibility of the rupee to the dollar. You and I would still be hauled up under Fema if we try to do that even for one dollar. Even today, in 2013! The monopoly of converting currencies is still with RBI-licensed authorised dealers. Let us not react in panic and issue laughable circulars like the one RBI did on August 14, 2013, reducing the limit of foreign outward remittances from $2,00,000 to $75,000 per year for individuals. Who is issuing such ridiculous instructions, if at all, to the RBI, causing an economic bloodbath in India?