Over the last several weeks the obsession with the INR has grown substantially and with every passing day this has become the topic of discussion and also a source of panic for the equity and bond markets. Given the structural issues related to inelastic imports and elastic exports the policy makers of the country never looked ahead to evaluate what could happen in a situation of significant risk aversion where capital flows would move out. Not only did the RBI and Finance Ministry never focus on the structural issues they tried to bridge the CAD over the 2011/2012 period by encouraging FII’s to buy into Government Bonds and also made the norms easier and the duration shorter for these flows to happen. The consequence of this was there to be seen three months back where there was a huge outflow due to selling of these bonds by FII’s which further exacerbated the fall of the INR which was as it is weak due to the increasing CAD.
The structural problem of CAD has been known to every one for a long time. Under the circumstances when it was very clear that the INR was overvalued on an inflation adjusted basis since 2009 the RBI should not have used INR appreciation as a tool to control inflation. It should have build up forex reserves by keeping the INR weak at a time when capital flows were strong. This would have kept imports expensive and made Indian exports more competitive and we would never have come to this situation of an explosive CAD. However let bygones be bygones and let’s focus on today.
The fall in the INR since the beginning of this year and more specifically over the last 4 months is sort of a step devaluation of the currency as the INR has fallen by nearly 25% in a short period of time. Typically such devaluations are strongly trade adjusting. Most of the negatives of the INR fall are already being felt in the economy in the form of higher inflation and higher subsidies on fuel, fertilizers etc. However given the fact that the economy is not growing the inflationary impact of the INR fall is not as drastic as manufacturers find it difficult to pass on price increases. This has also been aided by a general weakness in global commodity prices ex of crude oil. Although the INR fall has negated the benefits of the fall in global commodity prices the good part is that due to low global commodities we have not seen as severe pressure on company margins.
Although several Emerging Markets have seen their currencies fall some of the key competing economies for engineering goods, labour intensive manufacturing, electronics, Automobiles etc like China and Korea have not seen this kind of pressure. This makes Indian Textiles, Leather Products, Automobiles, Auto Ancillaries, Engineering Project companies, Ship Builders etc extremely competitive. A 25% depreciation is really huge and is sufficient to change the terms of trade hugely. The question then is that what should be the stance of the RBI/Government on the INR. Given that the move in the currency has been extremely swift and the INR is hugely oversold we should see a pullback come through anytime now which should take the INR back to the 62-63 levels to the USD. This would still be a 15% plus depreciation for the year. At this level the prudent policy now would be that the RBI should step in to prevent any further appreciation and use the flows as they come in to build Forex Reserves. This is what they should have done in 2009/2010 and they need to do the same thing now. China had a huge advantage in the last boom years of 2003-2007 where most EM currencies including the INR appreciated, while China kept the Yuan stable thus improving its terms of trade. The reverse is true as of now. In segments like BPO again Indian companies have a significant advantage given that the Philippines Peso has fallen just 8%. Pharmaceutical and IT companies are already taking advantage of the weak INR to improve their market shares.
Wage inflation in India is also subdued despite high Consumer Prices due to the slowdown in the economy. This is also good for boosting export competitiveness at a time when wage inflation is high in China.
The government on its part can do several things to boost exports. It will impact them fiscally to some extent; however it will be worth it as the main issue right now is to build a sustainable solution for the CAD problem. The government should increase the interest subvention for exporters from 3% to 5% & secondly increase duty drawback rates significantly. Given the substantial surplus capacity available in the country today it will lead to an immediate increase in exports. This will also be aided by the fact that the global economy is on the mend with improving economic data coming out of most countries (EXCEPT INDIA).
A weak INR will keep inflation elevated for some more time, however given that interest rates in the economy are as it is high and liquidity is tight no further monetary action will be required. On top of this if we see some steps coming out of the government which can aid FDI flows then it will be an added benefit.
The SEZ policy has broadly been a failure. Another initiative of the government could be to initiate the process of setting up 4 large state owned SEZ’s where companies could set up capacities for exports without the issues related to the conflicts of privately owned SEZ’s. However this will be more long term in nature.
Overall its time and there is an opportunity for policymakers to focus on addressing the Trade Deficit on a sustainable basis.
Markets and the INR seem to be in the process of forming a bottom sometime soon. Pessimism is at its height and there is negativity all around. In the domestic context, post passage of the Food Security Bill, Land bill etc we are unlikely to see major negative developments. Changes on Mint Street are also positive. Global Economic outlook is steadily improving and ex of the Syria issue the outlook for Equities looks positive. Banking stocks in India are today cheaper and more oversold than any time during the 2008 crisis. After being sceptical for the last few months I believe that now could be the time to take a CONTRARIAN BET.