The government’s measures for arresting the rupee's slide have failed. The approach needs a rethink
In the unenviable sequence of conceptually-flawed economic policies – to which also belong demonetisation and the Goods and Services Tax’s (GST) rate structure and collection system — the latest is the government’s response to the rupee’s fast-paced depreciation.
When the crude prices-current account deficit-rupee macroeconomic equation had started becoming unfavourable, the government’s early arguments focussed on external factors outside its control: oil prices, U.S. Federal Reserve’s interest rate policy, turmoil in the international currencies, etc. The Reserve Bank of India (RBI), fighting a solitary battle, defended the rupee in the forex market by dipping into its $425 billion stockpile of reserves. Roughly $25 billion was spent between April and September. Yet, the rupee went from about 65 to a dollar to more than 71 to a dollar. The RBI intervened thereafter very selectively, probably recognising the futility of resisting the slide.
The penny dropped then. Prime Minister Narendra Modi and Finance Minister Arun Jaitley, accompanied by the ministry’s mandarins, chewed over the current macroeconomic stress at a meeting last month that went on for more than two hours. RBI Governor Urjit Patel’s advice was heard, not heeded. Afterwards, assorted measures aimed at slowing the depreciation were announced. They related to hedging risks, short-term borrowings, foreign portfolio investments norms, limits on foreign investments in corporate bonds and restrictions on ‘non-essential’ imports.
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Jaitley’s reassurance
Mr. Jaitley reassured markets that the fiscal correction target would be met without a cutback in capital expenditure. Yet, it did not change market expectations. All in all, the response measures could not turn the tide. The depreciation continues unabated. 75-to-a-dollar is within a hair’s breadth.
That the measures failed is not surprising. When holding $400 billion in reserves has not arrested the depreciation, how can tinkering around for $8-10 billion in inflows stop it? A durable solution would be to attract stable, long-term capital, not hot money chasing arbitrage differentials.
The move to raise the import tariffs on select ‘non-essentials’ confers protection on local industries with competitive disadvantage vis-a-via imports. But were the items really chosen through serious analysis of the current account deficit? Import duties were ratcheted up on washing machines, but only on those ‘less than 10 kg’. Can the government explain why it considers imports of washing machines ‘10 kg and more’ essential? This is socialist-era redux. The rupee’s tumble has brought out the controlling tendencies that were retired in the 1990s.
Why have markets not bought the government’s reading of the macroeconomic situation?
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Where goes the rupee?
The government has defended its macroeconomic management as exemplary, saying that the rupee’s troubles are due to international developments beyond its control — rising U.S. interest rates and global crude prices. But these short-term difficulties have touched what are traditional vulnerabilities. The twin (fiscal and current account) deficits get stressed whenever crude prices surge or there is a dollar-investments sell-off. A bout of rupee volatility follows. The markets are readjusting their expectations of the twin deficits. The depreciation under way is confirmation that things have not changed, as is evident from the frequent use of stop-gap plugs rather than long-term fixes. In the four years since 2014, the NDA government has reduced the fiscal deficit by just one percentage point, despite the huge bonanza from the fuel taxes.
The policy, as conceived, was to tax when crude prices are low, use the proceeds so raised to balance the fiscal books, and whenever prices rise, reduce the tax rates. Done right, it could mitigate retail prices volatility and fiscal imbalances. But the government dithered on expenditure reforms, and so its dependence on the fuel taxes has grown. For example, Mr. Jaitley’s maiden budget had proposed urea prices decontrol, although he did not mention it in the speech. The plan was aborted in 2015.
A Finance Minister’s options narrow in an election year. Caught between voter and market expectations, Mr. Jaitley has decided to trim fuel tax rates, accepting a minor revenue loss for a cosmetic price relief. Plus, he ensured state-controlled oil marketers also cut retail prices and absorbed the losses. This has destroyed the discipline of deregulation being practised since 2010 for a trivial giveaway of ₹1 a litre. The reform reversed had held for the past eight years.
Central bank’s limits
In this situation, the markets looked back to the RBI (in vain) for bringing a pause in the rupee’s slide. The burden of expectations tested the RBI’s commitment to the new monetary policy framework. Its mandate is to target inflation. Its exchange rate management duties are limited to subduing rupee volatility. In not hiking the policy interest rate last week, the RBI has remained duty-bound and within mandate.
What the RBI can do, as it has in the past too, is to open special windows for the forex needs of crude oil importers. Taking this considerable source of demand-side pressures off the forex market could provide the rupee some relief.
