Outlook For The Indian Rupee

Revisiting my earlier thoughts on the Indian Rupee, I am more convinced now than before that the Indian Rupee is likely to depreciate to a new lower band versus the US dollar.

Since my earlier post about the rupee in November, it depreciated to 54 rupees to a US dollar, rebounded to 48 rupees to a dollar and currently trades at 50 to a dollar.

It has since become known that the Reserve Bank of India (RBI) intervened heavily to stem the decline of the rupee and as a result sucked out large amounts of rupee liquidity from the banking system (the RBI sold dollars and absorbed rupees) creating a severe short term funding crunch. In order to mitigate the crunch, the RBI cut the reserve ratio that banks have to maintain with it. The RBI also eased open various avenues for debt and other short term foreign capital to flow into the country.

While the RBI can ease out short term friction in the market, the RBI does not have the ability to determine the level of the rupee (no amount of foreign exchange reserves can provide it that ability).

So why is the rupee depreciating? And why do I believe that it needs to find a lower level of 55 - 60 rupees versus a US dollar range?

  • The reason is that the competitiveness of the Indian economy has been severely eroded due to supply rigidities in the economy as well as large structural shifts in demographics, urbanization and industrialization.
  • There are also numerous subsidies that have structurally built up over the last decade that are yet to be passed through fully to consumers. Examples include fuel (oil, natural gas, coal), fertilizer, power, civic user charges, rail freight etc. to name a few of the major ones. The pass through of these subsidies is inevitable.
  • Salary and Wage hike expectations in India have solidified at between 12 - 18% over the last several years. Indian companies sustained this over the last decade, initially through slack/operating leverage in their P&Ls, then through some productivity gains and finally through erosion of profitability and margins. However, we've gotten to a point where wage hike expectations are completely out of sync with any achievable productivity gains or operating leverage.
  • India has also lost competitiveness due to skyrocketing cost of capital (party due to crowding out by the government and partly due to drying up of capital inflows) and in a large number of cases due to complete lack of access to capital.

It is oversimplistic to define the phenomenon as inflation in the economy. A lot of what is happening is structural readjustment of the economy. When an economy with the population of India (1.2 billion people) goes through such magnitude shifts in structure in a free market, free press and democratic system, price and cost realignments are inevitable. The expected overshooting of prices are seldom corrected nominally (try reducing wages when talent is in demand).
In such a scenario, a depreciating currency smooths out the rough edges and provides adjustment room for the realigning economy. Obviously if the depreciation of the currency becomes a rout and if the declining value of the currency puts in motion a vicious cycle of heightened inflation expectations, things can get out of hand. But a lot more policy mistakes will need to take place before a scenario like that can play out.

The currency appreciation camp has only one thesis anchored on flight of capital from G7 currencies and substantial capital inflows into India. While in the past several years the correlation between capital inflows and currency appreciation has been perfect, I can see a situation where capital continues to flow into India (in moderation) even as the currency enters and stays in a depreciating trend. You only need to look back at the nineties to see how that can play out.