Although the rupee has stabilised after a steep fall, it remains under pressure
from multiple sources. Depreciation currently brings many costs in lieu of
few benefits
August was a particularly bad
month for the rupee. From
₹68.9 to the dollar at the end
of July, the currency
depreciated to cross the ₹72-
mark by the end of the month
(Chart 1).
While India’s perennial
current account deficit
underlay the currency’s
weakness, in August, the
average of daily prices of the crude oil basket that India imports fell to $59.35
a barrel from $63.63 in the previous month and $71 in April 2019. This
reprieve, combined with the depressing effect that slackening domestic
demand would have had on imports, should have strengthened the rupee,
not weakened it.
Global uncertainty
The rupee value declined in August, despite these beneficial economic
developments, because of the exit of foreign portfolio investors, which
resulted in a fall in net investments followed by an outflow of capital. In June,
net portfolio investment fell sharply, and then turned negative over the next
two months.
This decline and outflow contributed to the fall of the rupee (Chart 2).
Subsequently, when net portfolio investment turned mildly positive in
September, the rupee too, stabilised and registered mild appreciation. This
central role of foreign investment flows in influencing the rupee’s
movements make the currency vulnerable for the near future.
Clearly, uncertainty with regard to global output and trade growth was the
basic factor responsible for the deceleration and reversal in the volume of net
portfolio investment inflows. Evidence that the Indian economy too has
turned sluggish has not helped an already weakened investor sentiment.
These determinants of the recent depreciation of the rupee suggest that the
currency could lose further ground vis-à-vis the dollar.
With uncertainty and anxiety on the rise in the world economy, cross-border
capital flows are likely to shrink further, as wealth-holders flee to the safety
of dollar-denominated assets. This tendency will be aggravated if projections
of a plunge of the Indian economy into recession prove to be correct.
In normal circumstances, a rupee depreciation resulting from such factors
would come with a silver lining. By lowering the dollar value of India’s
exports, a depreciating currency could enhance India’s external
competitiveness and contribute to a rise in exports. However, given the
depressed demand conditions in the world economy, this outcome has not
materialised.
India’s exports over the April-September 2019 period fell by 2.4 per cent to
$159.57 billion from $163.48 billion in the corresponding period of 2018.
External borrowing
While exports are not responding, the depreciation is likely to have an
adverse impact on the health of Indian business, which has become more
reliant on external borrowing. As Chart 3 shows, much of the volatility,
especially the overall decline in net inflows, was on account of shifts in equity
investment. However, during the June-September period, when investment
inflows into equity markets fell and turned negative, flows into the debt
market were relatively stable.
This reflected a larger trend
in which Indian business,
attracted by the much lower
interest rate in global
markets and encouraged by
the relaxation of restrictions
on external commercial
borrowing (ECB), have
increased reliance on funds
borrowed abroad. Overall,
net ECB, that had fallen by
₹653 crore during April-midSeptember
2018, rose by ₹54,073 crore in the corresponding period of 2019.
The total stock of ECB rose 11 per cent from $193.4 billion to $214.1 billion
over the year ended June 2019.
An important contributor
to the rise was the easing of
restrictions on ECB by the
Reserve Bank of India. In
the past, funds could be
accessed through the ECB
route only by
manufacturing companies,
special economic zone
units, software companies,
non-banking financial
companies, and other
similar entities. This policy was revised to allow all entities that are eligible
to receive foreign direct investments and other specified entities like port
trusts and start-ups, among others, to borrow from abroad. Service
companies and trading entities could also access funds through the ECB
route.
The sources from which funds could be borrowed were also widened to
include any entity that is a member of the Financial Action Task Force and
the International Organization of Securities Commissions. This brought in
private equity firms and venture capital funds as investors in debt
instruments.
Foreign currency risk
The increase in borrowing that resulted from these policy changes has also
increased the exposure of Indian business to foreign currency risk. The
depreciation of the rupee would raise the rupee costs of servicing debt in
foreign currencies. This would either reduce profits or create losses, unless
the borrower had hedged the foreign exposure. According to market reports,
many borrowing entities, aiming to save on the costs of hedging and betting
that the rupee would remain stable — or even appreciate — had not covered
their foreign exchange exposure.
Here too, the RBI played a role. In a bid to ease access to foreign funds, in
November 2018 the RBI reduced the mandatory hedge coverage to 70 per
cent of the foreign exchange payment commitment, from 100 per cent.
It also reduced the loan tenure required for exemption from mandatory
hedging to five years from 10 years. This would have contributed to an
increase in unhedged exposures, raising the possibility that the rupee’s
depreciation has resulted in corporate losses.
To the extent that this occurs, rather than positively affecting growth by
enhancing export competitiveness, the rupee’s depreciation could dampen
investment and even worsen the ongoing growth slowdown. It has been
argued that the exit of foreign institutional investors from the equity and
debt markets can aggravate the credit slowdown by withdrawing liquidity
from the system.
In addition, we now have further reasons for concern about a possible
worsening of economic conditions on account of the impact that foreign
investors’ exit would have on the value of the rupee.
Source: The Hindu Business Line, India Tuesday, 24 December 2019