The government signalled its intent to defend the rupee last weekend. But the 5-point programme it proposed is more in the nature of a band-aid where more heavy duty medicine is required. The band-aid hasn’t done much to stop the bleeding. In early morning trade on Monday, the rupee plunged close to a percent to Rs 72.55 per dollar while the Sensex shed 1.11 percent to 37,667.56.
The measures are underwhelming but may have unintended and disastrous consequences. They seem fixated on the idea that short term flows are the solution to a falling dollar-rupee and widening current account deficit. The government expects some $8-10 billion of inflows to come in. If the measures succeed, they will end up increasing the vulnerability of Indian banks, companies and the financial system at large.
Take for instance, the proposal to ease mandatory hedging requirements for infrastructure loans. Easing such hedging requirements will increase vulnerabilities for local banks and the financial system, as former Reserve Bank of India Executive Director G Mahalingam warned in 2015. It will increase the risks for banks that are already struggling with a large proportion of loans turned bad. At one point in time, RBI wanted banks, which had lent to these unhedged companies, to increase their provisioning.
The government has proposed to allow companies to borrow externally up to $50 million with a minimum 1 year tenor compared to 3 years earlier. That is an attractive proposition for companies to take short term forex loans. Even hedging costs for this maturity would be lower. It also want to remove exposure limits of 20 percent for foreign portfolio investors to invest in a single corporate group.
These measures will end up increasing India’s short-term debt and worsen vulnerability yardsticks. At the end of March, short term debt (residual maturity) had climbed to 4 percent of total external debt. This short term debt also made up 52.3 percent of reserves. To be sure, these numbers are certainly better than 2013. RBI’s reserves kitty is also adequate.
However, remember that the current account deficit is also widening and reserves have been coming down as well. Some economists now forecast the current account deficit to breach 3 percent of gross domestic product in the current financial year. So, India’s gross short-term financing requirement (i.e. current account deficit plus short-term debt by residual maturity) would be equivalent to almost three-fourths of current forex reserves.
That’s, of course, if these measures succeed. But in today’s external environment, it will be difficult for companies to raise money abroad. The relaxations on masala bonds may not work as not many would be willing to take a bet on a sharply falling, volatile currency such as the rupee. In any case, sentiment is negative towards emerging markets and risk assets.
The world is in the midst of a brewing trade war. The United States is poised to raise interest rates at least twice more this year. Geopolitical tensions too are only increasing. The US seems adamant on imposing trade sanctions on Iran, a major oil supplier, and it could lead to a further rise in oil prices, widening India’s current account deficit and making it less attractive for foreign inflows.
The other measure proposed is to curb non-essential imports. It seems fair game especially because imports are likely to rise as investment demand and economic growth pick-up. That reeks of protectionism and could spark repercussions from trading partners.
It is also important to note that the current fall in the dollar-rupee has more to do with global factors than local. While they may not be perfect, India’s macro fundamentals are better than they were in 2013. Thus, there is no need for a knee-jerk reaction. India can choose to raise non-resident Indian funds through bonds or deposits, or allowing oil importers to source dollars directly from RBI.In the end analysis, however, the government and RBI are called upon to defend the rupee using such extraordinary measures with metronomic regularity. Instead of band-aids, deep surgery is needed. That would include structural reforms that will boost exports and prompt more stable foreign inflows in the form of direct investment.