I have overall been a supporter of Raghuram Rajan since the time he was appointed as RBI governor. My view has always been that we need someone who understands economics well and can look into the future to formulate policies as RBI governor instead of ex Bureaucrats that we have traditionally got. RBI’s thinking and actions have been a refreshing change over the last one year.
The overall policy stance on building defences for the INR last year, the change in focus to CPI, keeping liquidity relatively easy while targeting short term rates around policy rates, clearer communication etc have been extremely good steps from the RBI. The RBI has also removed tail risks for the INR by getting rid of their forward dollar delivery commitments and now holds a net long position in the forward markets. I have also argued that RBI’s inflation focus of getting CPI down to 6% is infact the best thing for bond investors as sustained low inflation will lead to a sustained bond rally.
However the INR policy in the near term has been a cause of concern. INR appreciation led by capital flows was the bane of the INR post 2007. I have argued in the past that we should have a weak INR policy till the time the CAD comes below 0.5% of GDP. The rupee should appreciate due to structural factors and not cyclical ones.
The fall in commodity prices, especially crude oil will save the country nearly $ 15 billion this year and also help reduce the Fiscal Deficit by reducing subsidies. However this is a stroke of luck and not due to any structural move by the Government or in the economy. The reduction in CAD in the USA is structural as they are now producing nearly 50% of their requirement of Oil & Gas. However India’s import dependence has actually gone up as production as continuously declined. On top of that we have increase imports of Coal, Edible Oils, and Electronics etc. What if the crude oil prices spike up again going forward due to any reason? The entire Trade Deficit reduction and Subsidy reduction argument will no longer hold then.
India has got nearly Rs 120000 Cr inflows into Debt and Rs 80000 Cr into Equities this year. However the overall build-up of reserves since the beginning of this year has been just around $ 20 billion i.e. just around the amount which has flowed in as Debt inflows. Forex reserves were $ 295 billion at the end of Dec 2013 and are $ 315 bn now.
The government is taking more time than was initially anticipated to bring about structural changes in the economy. This was always supposed to be a time consuming thing however expectations were that a start would be made sooner than later. However we do see some delays there. In such a scenario allowing a strong rupee builds up risks for the economy.
The INR has appreciated by nearly 5% against a broad basket of currencies since the beginning of August while holding steady against the USD. This includes advanced economy currencies like the Euro and the Yen where it has been in the magnitude of 5-6%. Most EM currencies have fallen by nearly 5-10% against the USD in the same time period. In the absence of any structural improvements in India’s external balance of trade this is extremely risky. This could lead to a cooling off of exports and a pickup in imports going forward as imports become cheaper and India loses the relative currency advantage in exports. Textile, chemical and auto ancillary exporters a big story in the stock markets could lose competitive advantage. The other major factor to consider is also that one of the major reasons for the reduction in the trade deficit has been the restrictions that have been put on import of Gold. Finally these restrictions are artificial and will not last forever. As prices of Gold come down and the restrictions are eased we are likely to see gold imports pick up again.
A strong INR also has the impact of keeping imported prices low and inflation lower than what it would have been in the case if INR was 4-5% weaker. The other big factor playing out these days is that due to a high forward premium of Rs 4.5-4.8 for USDINR most exporters are hedging their receivables while importers are going unhedged as the hedging cost seems too high to them. This is now building up another risk factor in a scenario where a reversal in capital flows could create a short term downside in the INR and hit the unhedged importers in a big way, which would then run to hedge and create more downside for the INR.
In conclusion I believe that the RBI should use relative INR strength to build reserves rather than keep the INR at levels which are not economically sustainable. Forex reserves could be $ 20 billion higher if this strategy is employed. Till CAD is sustainably under control and inflation much lower than current levels there is no case for a strong INR.