15 December 2011 No.

935

Why Indian Rupee hits record lows

In the past four months, the rupee has lost around 20% vis--vis the US dollar on a combination of external factors amid euro zone worries and economic global slowdown as well as deteriorating fundamentals on the domestic front.

The rupees slide has intensified in the last few days after the release of cyclical data indicating a slowdown of the economy and stubborn inflation. Renewed concerns about political inaction to implement second

generation reforms to boost private investment and industrialization may be the third ingredient explaining current market pessimism on the domestic currency outlook. Meanwhile, the RBI (at least for the moment) only intervenes in the FX market to manage volatility allowing the trendily correction.

The Indian currency hits a record low at 54.2 per dollar on Thursday 15th. We summarize the reasons behind this depreciation and remind its main macroeconomic consequences.

ECONOMIC RESEARCH Author:

Edgardo TORIJA ZANE

India hit by the financial channel of the international crisis

On 15 December, the USD/INR reached an all-time high of 54.2 (chart 1), the rupee depreciating for the four consecutive day. Deteriorating external conditions is the first reason of the rupee weaknesses. The slump of the rupee started four months back with the aggravation of the euro zone crisis and the deterioration of world growth prospects, which added volatility in international capital flows and prompted investors to flee emerging markets.
55.0 52.5 50.0 47.5 45.0 42.5 40.0
So urce : Reut ers

Chart 1. Exchange rate (USD/INR)

55.0 52.5 50.0 47.5 45.0 42.5 40.0 37.5

37.5 00 01 02 03 04 05 06 07 08 09 10 11 12

In the past four months, the rupee has lost more than 20% vis--vis the US dollar. This fall makes the rupee the worst-performing currency in Asia this year (table 1).

Table 1. Exchange rate

USD to local currency (15/12/2011) Chinese RMB South Korean Won Indian Rupee Indonesian Rupiah Malaysian Ringgit Philippine Peso Singapore dollar Thai Bath Taiwan New dollar Hong Kong dollar
Source: Reuters

6.4 1146.8 54.0 9050.0 3.2 43.6 1.3 30.9 29.9 7.8

On year change 4.3 -1.9 -15.8 0.0 -2.3 1.5 0.3 -0.7 -3.2 -0.1

Indian markets have been particularly concerned by reduced overseas inflows in portfolio investments (chart 2) leading to high volatility in both equity and fixed income market. The Sensex, the benchmark index on the Bombay Stock Exchange is also Asias worst performer since Jan. 2011 (chart 3).

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90 80 70 60 50 40 30 20

Chart 2. Es tim ate d allocation by fore ign ins titutional inve s tors in India bond and e quity m ark e ts (USD bn)

90 80

10 1

Chart 3. Stock m ark e t inde x (01/01/2011=100)

10 1

1 00

1 00

70 60 50 40 30
70 80
Shanghai H o ng Ko ng M um bai Ko spi (Ko rea) Taiwan Singapo ur
Source : Tho mpso n Dat ast ream

90

90

80

70

20
So urce : EPFR

10 08 09 10 11

10

60
01/11 02/11 03/11 04/11 05/11 06/11 07/11 08/11 09/11 10/11 11/11 12/11

60

As it has been mentioned many times 1 , the persisting current account deficit at around 2.5-3% of GDP, makes India more vulnerable to capital flight episodes than other Asian countries which run external surpluses (chart 4a/b).
20 Chart 4a. Curre nt account balance (% of GDP)
C hina H o ng Ko ng India Indo nesia M alaysia

20

25 20 15 10

Chart 4b. Curre nt account balance (% of GDP)

25 20

15

15

P hilippines Singapo re Ko rea Taiwan Thailand

10

10

15 10 5 0

5 5

0
Sources : EIU, Nat ixis

0
Sources : EIU, Nat ixis

-5 00 01 02 03 04 05 06 07 08 09 10 11 12 13

-5

-5 00 01 02 03 04 05 06 07 08 09 10 11 12 13

-5

Indias economy has traditionally relied on capital inflows to fund the currentaccount deficit. Indeed, unlike biggest Asian markets, growth in India comes along with mounting external financial needs and a growing external debt (chart 5), especially at the corporate sector level as the public debt is mostly financed through domestic savings. The increasing current account deficit is also a reason for the slow foreign exchange accumulation by the Reserve Bank of India since 2007 (chart 6). Increasing dollar demand from importers -fuel and gold purchases have been among the main contributors to import value growth- has been up to now served by an abundant supply coming from strong capital inflows.

See Monthly Report N10, India : slower growth, persisting imbalances .

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350 300 250 200 150 100

So urce : IIF

Chart 5. Exte rnal de bt (USDbn) 300

Sho rt term M edium /Lo ng term

Chart 6. FX Re s e rve s at RBI (e xcluding gold) (USD bn)

300 250 200 150 100

250 200 150 100 50 0 78 83 88 93 98 03 08 78 83 88 93 98 03 08

So urce: IIF

50 0

50 0

Notwithstanding, the worsening external financial environment makes the funding of the current account gap more challenging, especially as the Reserve Bank of India (at least for the moment) intervenes in the FX market only to manage volatility, allowing the trendily correction. Deteriorating Indian fundamentals have added to the worries
25 20 15 10 5 0 -5 -10 -15 05 06 07 08 09 10 11
WP I P rim ary articles Fo o d M anufactured pro ducts Fuel and po wer

The recent slump of the rupee is also due to worries over India's high inflation and slowing economic growth (charts 7 and 8). This is a clue to explain why the rupee is underperforming other emerging market currencies also hit by the crisis.
25 20 15 10 5 0
3 10 9 8 7 6 5 4 Services Industry A griculture

Chart 7. Whole s ale price inde x and its com pone nts (%, Y oY )

Chart 8. India GDP grow th and s e ctorial contributions (%, Y oY )

-5 -10
So urce: CEIC

2
Source : CSO

1 0 Q1 2010/11 Q2 2010/11 Q3 2010/11 Q4 2010/11 Q1 2011/12 Q2 2011/12

-15

The release of cyclical data indicates a slowdown of the economy, in particular in the industrial sector which has contracted by 5.1% YoY in October alongside with a steep slowdown on good exports growth (chart 9). On the other hand, inflation remains high despite slowing activity, the release of November inflation marked a 9.1% on year growth that also disappointed the markets.

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80 60 40 20 0 -20

Chart 9. Indus trial porduction and e xports (% ch, Y oY )

80 60 40 20 0 -20

M archandise Expo rts (in USD)

So urces : CSO

-40 07 08 09

Industrial pro ductio n

-40

10

11

The Indian economy is encountering a number of difficulties. Stagnating manufacturing activity and the very slow improvement in hard infrastructure investment raise concerns on the structural obstacles to growth and the capacity of the economy to sustain 8% growth rates like in the period 2003-2010. The first obstacle to achieve high growth rates is the under-development of infrastructure. High investment during the 2000s has been concentrated in service activities (intra-city connectivity, modernization of airports, telecommunications) rather than in industry sectors or rural activities (energy, water access, road networks, electrification, irrigation). The pro-urban and pro-services bias of Indian growth has led to rising income inequalities (in detriment of farm workers), creating also a structural inflation problem. Indeed, the middle classes (2.7% of households in 1995 vs. 12.8% in 2010), which have expanded rapidly in the cities, has led to a brisk increase in demand for food products that were once the privilege of a minority (e.g. milk, meat, eggs), while farming productivity (and supply) has increased very slowly. Food price inflation tends to be self-sustaining, as food accounts for about 40% of consumer purchases inducing second round effects from higher input costs (wages in particular). The second obstacle for strong expansion is the manufacturing sectors relative lack of access to credit, as the banking system fuels resources to government needs (a statutory liquidity ratio obliges banks to place 24% of their assets in public bonds) and to priority sectors (by Law, agriculture and small industries shall receive 40% of lending). Second generation reforms being delayed At a time when public resources to develop infrastructure remain insufficient (the central government revenues are equivalent to only 9% of GDP) economic reforms appear necessary whether to increase public revenues or to attract private investment. However, the progressive reform process launched in the 1990s with several liberalisation policies has stalled in recent years. As a consequence, a certain lack of business confidence is now becoming palpable.

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The recent government decision in late November to allow 51% foreign ownership in multi brand retail (and 100% in single-brand) and then, within days, to backtrack on that decision amid strong opposition parties pressure has been interpreted by business circles as a proof of ungovernability and policy inaction in India, especially as the ruling coalition (the UPA) which launched the reform enjoys a majority in the Parliament. The impact of FDI reform is difficult to assess and it is definitely subject of a controversy. On the one hand, traditional shop business would be hurt by the entrance of big international players. On the other hand, the liberalization policy would have assured huge FDI in the retail sector and, as some say, avoid wastage of perishable goods easing inflationary tensions. The other reform that has been scaled back since 2009 is the introduction of a good and services tax. This tax was proposed by the current government to replace all indirect taxes levied on goods and services by the Indian Central and State governments. Again, the convenience of the measure is under scrutiny. The reform has the advantage to harmonize the consumption tax system in the country ending the long standing distortions of differential treatments of manufacturing and service sector. But it founds strong opposition in several States which would lose a direct control of consumption tax revenues. It is often argued that the GST reform is against the spirit of federalism enshrined in the Constitution. Other tax reforms seem also necessary with only 3% of the Indian population paying the income tax. Renewed concerns about political inaction to implement second generation reforms to boost industrialization may be a third ingredient explaining market pessimism concerning the domestic currency outlook. It is very difficult to assess to what extent the rupee fall is being affected by the external shock and deteriorating domestic fundamentals and confidence, although both factors are considered a matter of concern. Some macroeconomic consequences of Rupees weaknesses Near-term, the rupee may weaken further on growth concerns and capital outflows. As tensions in the international markets are likely to remain, the current conditions are unfavourable for rupee prospects. It will not be surprising to see the dollar reaching 55-56 rupees in the months to come, contributing to the slowdown of domestic demand. Some industries, like the pharmaceutical and the technology related services could benefit from a cheaper rupee, boosting export value in rupee terms and benefiting from higher competitiveness. Indeed, high inflation in 2010 and 2011 has been a reason for real currency appreciation (Chart 10).

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Chart 10. Re al e ffe ctive e xchange rate inde x 105.0 102.5 100.0 97.5 95.0 92.5
So urce : RB I

105.0 102.5 100.0 97.5 95.0 92.5 90.0 09 10 11

90.0

The non-desirable macroeconomic effects are large. A depreciating rupee makes imports costlier, and has a major impact on the country's oil bill. Not only this adds to the current inflationary pressures but it also raises the question on the effect of the depreciation on the trade balance. The country's heavy dependence on energy imports means that the absorption of the trade balance will be unfortunately more effective by reducing the domestic absorption rather than changing the relative price of imports. Therefore, the currency depreciation will come along with slower growth in the short-term. Many of the country's import-dependent industries will see costs going up. A weak rupee is definitely bad news for corporate which have been heavily borrowing in foreign currency benefiting from low international interest rates, especially since the monetary easing of 2009 in major financial centres. It is not only the aggregate debt, but also the interest service which will become costlier to repay. Rupee depreciation is also challenging the current monetary policy, focused on finding the right balance between growth, price stability and a smooth funding for the government deficit. RBI is expected to mark a pause on the tightening policy, after 13 interest rate increases since March 2010, to sustain economic activity. Nevertheless, any monetary loosening will be objectionable as it could fuel appetite for foreign currency. Unless the monetary authorities decide to impose strategic capital controls, the risk of an escalade in rupee depreciation will force the RBI to contain capital flight by letting an increase in the domestic interest rate, which will again hurt growth. The RBI could alternatively rely on its huge FX reserves to contain the depreciation, although a decrease in the amount of international assets could trigger doubts on the path for the rupee. Other steps to boost dollar inflows could come from relaxing conditions on foreign borrowing by companies and on foreign investment limits in debt. The RBI will issue a statement on the rupee at its mid-quarter monetary policy review Friday 16th which is expected to shed lights on next movements.

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Conclusion

To summarize, we understand the rupee strong depreciation as a consequence of the tensions in international markets leading to capital flight but also as the manifestation of an unbalanced high-growth regime. The rupee depreciation will benefit some industrial and services related exports, although it is not clear that the impact on the trade balance will be positive in the short-term, as a lower rupee makes imports of necessary input much costlier (fuel in particular). There is also an interrogation on the effect of a rising USD on the corporate who expand its activities relying on FX debt. High inflation in 2010 and 2011 makes this correction in the exchange rate somehow necessary to re-establish real competitiveness. Notwithstanding, the absorption of current account unbalance (in case the retreat of international flows persists) will certainly come principally through domestic demand slowdown. That is why in the current context, achieving 9%-9.5% GDP growth, as targeted th by the authorities for the 12 Five year Plan (2012/2017), will be a very difficult task.

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