As the Rupee hits new all time lows against the Dollar, it is natural to look for ways to arrest this slide and look for solutions to this problem.
The problem however is the not the Rupee slide itself – the fall in the Rupee is the symptom of underlying problems and you have to look at those problems to find solutions.
You can take short term measures to stop the fall but if they are not backed by long term efforts to correct the underlying problems, nothing will change and we will have to deal with the same situation 8 or 12 months down the line.
RBI allowing banks to set their own interest rates on NRE deposits and making these NRE deposits tax free is a good example of a short term measure. That would have surely helped bring in foreign exchange at the time, but since January, the Rupee has already lost 9% against the Dollar so whatever gains an NRI will make on the interest have already been nullified by the loss in the value of Rupee, and any similar measure is not going to be as attractive a second time.
While such short term measures are essential at the time of volatile downturns, past experience has shown that they aren’t enough to reverse the trend over a longer duration.
The exchange rate depends on the demand and supply of INR and foreign currencies, and that relationship is shown in the current account and capital account of the country.
Simply put, the current account is the account that shows the imports and exports of goods and services and the capital account is the account that shows the money invested by foreigners in India, and money invested by Indians outside the country.
As far as I know, India has never had a trade surplus, which means it has never exported more than it imported and the deficit that occurs as a result of this has been met by investments by foreigners in the form of FDI and FII inflows in India. But recently, even those have slowed down putting pressure on the currency.
A simple fish – bone diagram will help explain this better.
Current Account Deficit
The current account deficit as measured by the difference between exports and imports of goods and services has never looked in worse shape. The trade deficit last fiscal was $184.9bn, and this is as high as 9.9% of GDP.
On the import side, higher oil prices, and gold imports are causing a lot more outflow than previous years and as I wrote in January, these two alone contributed to 43% of Indian imports.
Exports have been slowing down too and in fact March of 2012 actually saw a drop in exports from a comparable period a year ago, something that hadn’t happened for more than two years.
Capital Account Deficit
On the capital account, FDI has been in the news for all the wrong reasons. Even historically, India has attracted lower FDI when compared with other emerging countries and the lack of reforms and the inability to make any progress on issues like FDI in multi-brand retail means that India has been below its potential in attracting FDI from the world.
FII investments have dried up due to the global flight to safety because of the resurfacing Euro concerns, but even before that, after the GAAR announcement in the budget, the FII volume had reduced quite a bit in the Indian market.
Investments also depend on the general economic environment and that hasn’t been good in the past few years leading to an environment which doesn’t inspire confidence in investors (both global and domestic) to put money in the market.
If you look at these factors, some of them are within India’s control and some aren’t – India can’t do anything to influence oil prices, or do anything about the Euro problems but it can certainly take steps to simplify labor laws, get clearances fast, build infrastructure to get foreign investments and other such things. These things need to be done anyway to help improve the standard of living of the people in the country, the volatile Rupee fall just gives a sense of urgency to carry them out.