Controlling inflation, reducing volatility key to stabilising rupee, economists say

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Economists have called for a cut in excise duties on petroleum products and an increase in the Reserve Bank of India’s policy rates to mitigate the adverse impact of a weakened rupee on the domestic economy. Cooling domestic inflation and calming market volatility are key to stabilising the rupee, given the situation that emerged from Russia’s invasion of Ukraine, they said.

The immediate impact of the conflict on the Indian economy will be felt through inflation, an increase in the current account deficit (CAD), and rupee depreciation, the economists said.

After reaching a record low of 77.14 to the dollar on March 7, the rupee has since gained to 76.25 as of March 16. This still represents a fall of 2.28 percent since the beginning of the year, when it was 74.51.

Rapid currency fluctuations also make assessments of investment returns difficult for foreign investors and depress market sentiment.

Aditi Nayar, chief economist at rating company ICRA, said an excise duty cut on prices of petrol and diesel is needed at the earliest to stem inflation, especially of wholesale products, from spiralling further upwards. The revenue loss to the Centre in FY23 from a rollback in cesses to the pre-pandemic level is estimated at Rs 92,000 crore.

Excise duties

The Centre had slashed excise duties on petrol and diesel by Rs 5 and Rs 10, respectively, on Diwali eve to soften the impact of elevated oil prices. Since then, oil marketing companies have held domestic prices of the two fuels although world oil prices were volatile.

Global prices soared following the Russian invasion of Ukraine. Brent surged to $139.13 a barrel on March 8, its highest in 14 years, although it has since dropped to about $100 a barrel.

Nayar also stressed on the need to increase fertiliser subsidy to mitigate the impact of high input prices on the farm sector.

“Fertiliser subsidy for FY23 has been budgeted at Rs. 1.1 trillion (Rs 1.1 lakh crore). Given the surge in input costs, this would need to be enhanced appreciably during the course of the year,” she said.

Other experts cautioned that the focus should be on lowering volatility in the currency.

“The truth is that the government can’t do much in terms of policy to quickly reverse the fall of the rupee,” said Devendra Pant, chief economist at India Ratings. “They can only try to control the volatility of the currency, since it’s based on a demand and supply mechanism. The Reserve Bank of India has the option to intervene and banks can then sell US dollars, provided the capital flows remain stable. We have seen how, at times of crisis, the flight of funds takes place.”

Oil & inflation

ICRA estimates that an average crude oil price of $130 a barrel in FY23 would widen the current account deficit to 3.2 percent of GDP, crossing the 3 percent threshold for the first time in a decade. India’s CAD last exceeded 3 percent of GDP in 2012-13, when crude oil prices were elevated and gold imports soared.

On the other hand, India Ratings pointed out that a $5/barrel increase in crude oil prices will translate into a $6.6 billion increase in the trade/current account deficit. India imports roughly 85 percent of its oil requirements and higher oil prices are expected to raise the bill for imported crude.

State Bank of India group chief economic adviser Soumya Kanti Ghosh expects the rupee to plummet to a new low of 77.5 against the dollar by June if the situation does not improve.

Ghosh stressed that if the average oil price jumps to $100 per barrel in FY23, the country’s current account deficit will pull back growth to 7.6 percent from the government’s earlier estimate of 8 percent, and inflation will rise to 5 percent from 4.5 percent earlier. Subsequently, the current account gap is expected to increase to $86.6 billion, or 2.5 percent of GDP.

“The government can, for now, limit the passthrough of high oil prices,” said Sujan Hajra, chief economist of Anand Rathi Securities. “Yet, this might turn out to be challenging if the situation persists or the rise continues. We expect the RBI to follow global cues and start raising policy rates, but moderately.”

“Investors are keen on gauging the impact from the recent spike in crude on the economy,” Kotak Securities said in a report. “Many hypotheses seem to ignore the stage of the cycle just prior to an inflation shock. We have not seen aggressive loan growth recently that can cause high stress. However, we might see slower pick-up in credit demand when borrowers weigh the benefit of putting fresh capex because a weak consumption cycle could limit demand.”

LIC listing

Economists also believe the listing of the Life Insurance Corporation of India will impact the rupee exchange rate. LIC currently holds about Rs 23.5 lakh crore worth of government bonds, higher than even what the RBI holds. LIC’s G-Sec holdings are about 19 percent compared with the banking system’s ownership of about 38 percent.

“Thus LIC’s listing should augur well for the bond market as the insurance behemoth may have to deploy a greater share of inflows in safer avenues domestically. This is a plausible option as banks may have to readjust their deposits into credit as the economic recovery gains momentum,” Ghosh pointed out in a research note.

This view is supported by other experts, who said the move will also calm the frayed nerves of investors and improve market sentiment. It has been widely reported that the government has been considering delaying the LIC listing at a time when the stock market has swung wildly.

While the insurance behemoth had been expected to come out with its initial public offering in March, the government has hinted the date may be delayed in order to maximise realisations from the listing.

“The LIC listing should be deferred to next year,” Nayar said. “The government has already done enough market borrowing this year.”

The likely spill-over of the LIC IPO to FY23 would augment the government’s non-debt capital receipts in that year, she said.

Costly imports

While prices of edible oil and petroleum, two of the largest commodities imported from Ukraine and Russia, have shot up, the cascading effect of a fast-depreciating currency is set to result in higher prices of imported gems and jewellery, fertilisers and capital goods.

On the face of it, a depreciating rupee is good for India’s exports. As the local currency weakens, overseas buyers get more purchasing power, thereby making Indian exports more competitive. However, the same process makes imports more expensive for Indian buyers.

This means that manufacturers and exporters will face higher production and processing charges as imported inputs become expensive. This is expected to hit micro and small exporters the most, exporters said.

According to industry estimates, at least 50 percent of India’s exports involve imported input goods or raw materials. This includes the two largest constituents of India’s exports—petroleum products (based on processing imported crude oil), and gems and jewellery (imported gold and diamonds).

Other major exports such as electronics, organic chemicals and pharmaceuticals are also heavily dependent on imports. The recent slide in the rupee will push up the final price of such goods manufactured in India.

The rupee has fallen steadily over the past two weeks as foreign portfolio investors pulled money out of the stock and bond markets amid global uncertainties caused by the war in Ukraine. While the local currency has recovered partially in the past two days, experts said the rupee is expected to stay volatile in the foreseeable future.