The surprise hike in the RBI repo rate sent the message that the inflation situation is grim and that the central bank will now do everything to contain it. The commentary changed from growth to inflation. But somewhere in the background was the currency which was a cause for concern as the rupiah had been under pressure for a long time and the RBI was trying to stabilize the ship through intervention. But volatility continues to prevail in the forex market and there is market panic.
The Rupee has long been in the Rs 76-77 range supported by the intervention of the RBI through the sale of dollars and swap agreements with banks. But things changed with the Fed aggressively raising rates and promising more in the coming months, the currency market took a big hit. There are roughly three factors that need to be looked at to understand the future course:
Inflows and outflows of dollars from the system
The fiscal year has just started so there are no trends as such to be seen. But given the ongoing developments, the following can be surmised. The trade deficit will certainly widen this year because if export growth can be maintained, imports will increase at a faster pace.
The reason is that both oil and non-oil imports would increase. Oil rose further due to the price effect. For non-oil imports, the demand is related to the growth process and as the industry picks up, the demand for imports also increases.
Add to that the fact that world commodity prices have gone up, it means the overall import bill will go up. Relatively subdued global economic conditions will translate into growth in remittances (the expat population needs to have jobs overseas) and software revenue. We’re actually talking about the current account deficit rising this year to approach 3% of GDP, which will be almost double that of FY22.
Capital flows will tend to become capricious. This can already be seen in REIT flows which are currently negative and will remain so as the Fed is aggressive in its rate hikes and investors look inward rather than emerging markets. FDI flows could also plateau at current levels as investors examine opportunities in the United States (which is the largest provider of FDI to the rest of the world). External commercial borrowing may no longer be attractive given that interest rates in the West have risen – the 10-year US Treasury is close to 3%, nearly 150-200bps higher than during the EX22. All this means that the external account would be in deficit and that the accretion observed last year will probably not happen again this year.
The external factor
When the dollar strengthens, other currencies tend to weaken and this is a global phenomenon. A depreciation cannot therefore be ruled out and is even necessary so that our exports do not lose their competitive advantage. It is something over which we have little control. It looks like the dollar will continue to strengthen throughout the year as the Fed tightens its controls.
So far, the RBI has ensured that volatility is reduced by intervening selectively. But for how long can the central bank do this, because any direct support through swaps or sales will cause foreign exchange reserves to be depleted. Putting all these factors together, a depreciation of the rupee seems inevitable and a rate of Rs 78 or 79/$ will be tested in the coming months.
Now, what does a weak rupee mean?
First: Import costs are increasing, further widening the deficit.
Second: Imported inflation results from higher commodity costs being passed on to the consumer through higher prices. This is obvious for fuel, but it would also work for chemicals, metals, electrical machinery, etc., which will make automobiles, electronics, etc. more expensive. Imports represent around 20% of GDP in nominal terms, which is quite high.
Third: The government would be better off as tax collections would increase with GST, with excise and customs yielding higher returns with increased taxable income.
Fourth: The RBI will additionally have to worry about inflation as this will hamper taking action to control rising prices.
Fifth: Borrowers from foreign markets will have higher servicing costs, especially if they are not adequately covered. This will be something that lenders will be worried about. In fact, it will also prevent companies from borrowing in this market with rising costs.
Therefore, the forex side of the economy is the new emerging challenge for policy makers. First it was inflation followed by interest rate hikes. The currency is also now in the spotlight and the task of the central bank is getting tougher. The intervention leads to further expectations. Doing nothing also becomes self-fulfilling. Central banks must therefore manage this trinity of prices – raw materials, capital and currency, this year with a balancing act.
(The author is Chief Economist, Bank of Baroda and author of Lockdown or Economic Destruction. Opinions expressed are personal)
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Posted: Saturday May 14th 2022, 08:19 IST