There are several problems with the slide of the rupee, which on Tuesday fell to a record low of 70.08 against the dollar before recovering slightly to close at 69.89. The biggest is that it has not lost enough ground. A second issue is that the Reserve Bank of India may have been forced into a wrongheaded strategy of currency management. A third is that, due to perception problems and political compulsions, policy will probably continue to be wrongheaded.

There are reasons why a weaker rupee would be good at the moment.

The Indian economy has a large trade component: imports plus exports amount to over 40% of gross domestic product. India also has a huge and growing trade deficit – it exports a lot less in the way of goods than it imports. The major reason for this is the higher cost of crude and gas. Trade data for July indicated a deficit of $18.02 billion, the highest monthly deficit in five years. That was up from a deficit of $16.6 billion in June.

India also has a huge and growing current account deficit – its net forex outflow exceeds net forex inflow. Although it has a surplus on invisibles (remittances, tourism revenues) and overseas services earnings (mostly from information technology and information technology enabled services-related work), the current account deficit hit 1.9% of GDP in 2017-2018.

It is headed for 2.5% of the GDP, maybe for 3%, according to most estimates. That is a ballpark of $60 billion-$65 billion. A weaker rupee would stimulate exports of both goods and services because those would become cheaper in forex terms. It would also put up a natural barrier against “non-essential” imports because imports become more expensive in rupee terms.

In a comparative sense, the rupee has not lost ground against other emerging market currencies and hence, exporters such as Bangladesh, Vietnam and China, among others, remain just as competitive in pricing terms when it comes to exporting to hard-currency areas.

The inflation-election question

Let us suppose the rupee loses more ground. We discussed the upside of this in this article in published on July 6. The downside is inflation. India has to import fuels, and solar equipment to meet its energy needs. It has to import electronic components to meet its digital communication needs. Those things would become more expensive in rupee terms and those costs would be passed on.

Higher inflation is a potential nightmare for a government headed into elections. Higher inflation could also retard possible acceleration in India’s growth rates. So there will be political compulsions to keep the rupee high. The likelihood of such a policy is higher because this government seems to have a fair number of people who believe in a strong rupee as an article of faith.

As a matter of fact, recent measures taken to supposedly promote “Make in India” have already made imports more expensive. The government has raised import tariffs on some 400-odd items. This means that domestic manufacturers will also raise their prices and, given less fear of competition, produce shoddy, low-quality products as well.

We saw this happen for 35-odd years while Indian policy kept imports out. We will also see a lot of smuggling of foreign goods and the development of a parallel hawala market in forex, where the rupee will trade at a substantial discount to official rates.

Instead of higher customs duties, a weaker rupee makes more economic sense. Customs duties are discretionary and stay high until some policymaker brings them down, regardless of any changes in currency value. Cutting or raising tariffs is also the sort of decision influenced by businessmen close to government who can make large profits from an anti-import policy. The rupee, on the other hand, will recover ground automatically if the current account swings back into balance and that would make imports cheaper and force local manufacturers to be more competitive in price and quality.

External crises

The sensible thing for the Reserve Bank is to ensure the rupee devalues predictably rather than through jerky moves. This involves occasional intervention in currency markets to smoothen out the rupee’s downwards trajectory, while letting it slide gradually.

Instead, there is an opaque policy situation, since nobody knows what the Reserve Bank intends or how heavily the government will pressure it to keep the rupee strong. The central bank has already spent large amounts, selling dollars to keep the rupee strong. In the past four months, its foreign exchange reserves have depleted by about $18 billion (roughly 4%) though some of this is because of currency depreciation of other hard currencies versus the dollar.

External crises invariably affect the Indian economy – the energy exposure ensures that and so does the massive trade component. The only way to deal with that is to export enough to balance off the imports.

The isolationist Licence Raj ignored the elephant in the bedroom when it tried to keep out foreign goods. India had almost zero-growth between 1973 and 1984 due to rising crude prices. It maintained rigid official exchange rates, imposed 320% duty on imports and allowed Indians travelling overseas to spend $50 per year. Meanwhile, the rupee traded at almost half of the official value in hawala and any Indian who went abroad smuggled currency, or made “arrangements” with family settled abroad.

The Indian economy has been slammed by pretty much every global economic crisis you can name. The invasion of Kuwait triggered the crisis that led to liberalisation in 1991. India was sideswiped by Asian Flu and Russian default in the 1990s, by Subprime in 2007-2008 and by the European crisis in 2011-2012. It was affected by spiking oil prices when the United States invaded Iraq as well.

There is always going to be a crisis – be it the lira, or America’s trade war, or whatever. Then, the rupee will be targeted. Traders will panic. The Reserve Bank will respond with a massive intervention that pulls the rupee back sharply. Then, the currency will get hammered again, when the next crisis blows up. This cycle will rinse and repeat endlessly.

There is always going to be a crisis – such as America’s trade war – and the rupee will be targeted.

Limited reserves

India does not have the reserves to safely maintain an ad-hoc trading policy where the Reserve Bank keeps trying to push the rupee back up while the market pulls it down. Reserves on August 3 amounted to $403 billion – that would be about 10 months of import cover. In other words, India’s total reserves amount to about 17% of GDP.

Thailand blew reserves worth 22% of its GDP in 1997 trying to defend the baht. It did not work. The Baht fell and the Thai economy contracted by about a third in dollar terms. Indonesia went through a similar but less extreme version of the same disaster.

Coming back to India, around $220 billion worth of overseas debt repayments (government obligations and corporate debt) are due within 12 months. Some will be made out of overseas earnings. But a large chunk will come from dipping into reserves – corporates will buy dollar or euro as required. In practice, assuming that the current account deficit hits $65 billion, there will be a drain on reserves.

More dangerously, Foreign Portfolio Investors have around $200 billion invested in rupee-denominated debt and rupee-denominated shares. These investors could, in theory, sell all those holdings and exit in a day. There has been substantial Foreign Portfolio Investor selling over the past few months. The reserves are not that comfortable. The Reserve Bank should not spend large sums to “protect” the rupee. It should spend as little as possible, to ensure the rupee depreciates gradually.

However, given political compulsions centred on inflation, the central bank will probably spend a fair amount of reserves to keep the rupee overvalued. This will be poor policy. We will get the inflation; we will get shoddy goods; we will see a resurgence in hawala trades; and exporters will not get the benefits of an officially weaker rupee. If this seems like a gloomy prognosis, it is. Unfortunately, it is also the likeliest outcome, given India’s economic history.