Thursday, December 1, 2011

India: The Rupee.

Don't fret about the Rupee

1 DEC, 2011, 04.29AM IST, 
The Rupee's depreciation against the dollar is a source of consternation, inflation, heart-break and hedge-break. The Reserve Bank thinks this is no big deal. The current account deficit is too large, so imports must come down and making imports expensive via a cheap rupee is the way to bring them down.

In any case, the rupee's exchange rate against a basket of currencies, weighted for trade and taking out the impact of relative inflation, is still higher than its level in either 2004-05 or in 2009-10. So why worry?

There are two reasons why the large current account deficit might not be a true reflection of real economic activity. One is that a large part of the additional imports are on account of gold. Gold imports are up 11% in terms of tonnage and 44% in terms of value, from January to September. At $37 billion, this is a huge part of our import bill.
Indians are traditionally greedy for the yellow metal. But of late, they have been wrapping up their greed in the cold rationality of hedging against inflation. With inflation persistently high and neither bank fixed deposits/ small saving accounts nor mutual funds guaranteeing a rate of return that will at least protect the value of investment, leave alone yield a positive rate of return, it seems entirely sensible to invest in gold.

In the process of importing gold in such huge quantities, this very act of hedging against inflation depreciates the rupee and feeds inflation: imports become more expensive in rupee terms, all dollar commodity prices turn dearer in rupee terms.
If the government were to offer people inflation-indexed bonds, it is possible that many of them would turn away from gold. Investing in gold is disastrous for the economy. 

Financial savings have come down from 12.1% of GDP in 2009-10 to 9.7% in 2010-11. 

Blame the yellow metal for the fall in financial savings, reducing funds for investment. So, if the government were to come out with inflation-indexed bonds, which offer investors a positive rate of return, whatever the level of inflation, some of the demand for gold would mute, imports would come down and the downward pressure on the rupee ease.
Another factor driving up imports is possible interest rate arbitrage carried out through trade. Not everyone can borrow abroad, given capital controls. However, anyone can export and import. Over-invoiced exports would bring short-term capital borrowed cheap into the country. This can be deployed at much higher rates of interest in the Indian economy. And to repay these loans raised abroad, you only need to over-invoice some imports.
This game works so long as the exchange rate is relatively stable. If the rupee's slide is more than the difference in the domestic and foreign rates of interest, the game runs out of steam.

Sure, such arbitrage would push up volumes of both imports and exports but not widen the current account deficit: repayment would be equal to borrowing, except for the interest element, which would not be high. But Indians are emerging market leaders in outward investment.

Such investments would also require the support of additional funds. If some of the additional requirement abroad is met with funds taken out of the country through over-invoiced imports, it would widen the current account deficit. This, of course, is at the level of conjecture but describes an entirely possible scenario.

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