Posted in Finance Articles, Total Reads: 1473
, Published on 23 August 2012
On the morning of 31st May 2012, after reading the headlines “Rupee falls to a new low”, my father exclaimed, “I wish you were in the US right now, sending Dollars home". Ironically, the “expensive” dollar was the reason my father refused to send me to the US to complete my post graduate education after I graduated in June 2010 (The exchange rate at that time was 1USD= Rs. 46.50). That was my first brush with the greenback and the affair has continued since.
Today, as a student of the capital markets, I wish to put my learning into practice and see how the economic theories I learnt in class apply to the current heartache caused by the dollar.
The Demand Side
Current Account captures the difference between the imports and exports of goods and services in dollar terms. Here, we consider two commodities that account for most of our imports and drive the demand for the Dollar.
Let us analyze the consumption of oil, one of the most essential commodities and the chief driver for the demand of dollar in India. Even though the rupee depreciated from Rs 48 to Rs 56 in the blink of an eye and the price of crude stayed put close to a US$100 a barrel during the quarter ended 31st December 2011, the demand for crude was not affected, as India imported nearly 3.45 MBPD during FY 12. In value terms, crude imports rose 41% to US$141 billion.
Any undergraduate text book will explain that when currency weakens, imports become more expensive and people consume less. It's a way the currency and demand adjust themselves. In India, it doesn't work that way. Here, the currency slips, imports become more expensive but consumption does not fall.
What happens then? The currency further slides and slowly you find yourself in the midst of a vicious cycle. That's when a flexible exchange rate loses its significance. It's a point where economics ends and politics begins.The subsidy provided by the government artificially kept the demand high and also caused the government finances to take a severe hit. Moreover, the severe shortage of Dollars because of fund outflows by foreign investors resulted in the government hiking the price of fuel sharply.
This further stoked inflation, already at dizzying levels because of supply side constraints, which affected the common man in the most extreme way possible. The prices of essential commodities such as food and milk went up drastically. The cost of travelling by public buses, once considered to be the most economical form of transport, increased by nearly 50%.
India’s been fascinated by gold since time immemorial and consider it to be the safest form of investment. This is reflected in the fact that India is the largest importer of gold in the world and accounts for one-third of the world’s demand. The gold import bill has risen from US$4.1 billion in 2001-02 to US$33.8 billion in 2010-11. As per the data released by ASSOCHAM India, gold’s share in total import bill of the country has gone up from 8.1% in 2001-02 to 9.6% in 2010-2011. This accounts for the major outflow of the Dollars from the country and has a major impact on Fiscal Deficit. The table shown below gives us an overview of the demand for gold.
Source: RBI website
However due to the depreciation in local currency and rising fiscal deficit figures government has been taking some strict measures in order to curb the demand of gold by imposing 1% excise duty on unbranded jewellery and doubling the customs duty on gold to 4%. The outcome of such measures is quite evident as India’s gold imports slowed to 200 tonnes (-30% YOY) in Q1 FY12. 
The Supply Side
Capital account records the flow of money in and out of the country. For a currency to be stable, the Dollar inflows in the capital account should match the deficit in the current account and vice versa.
1. Capital Account Flows
In order to finance the gaps created in the current account by oil and gold, India needed to finance it by attracting Dollars for investment. And Dollars flowed in thick and fast due to the high returns on investment and the higher interest rate on offer. Using the interest rate parity theorem, we realize that the interest rates need to be high in order to ensure that there are sufficient capital inflows in order to finance the deficit, as is the case today, where the interest rates on offer in India are nearly 8% and near zero everywhere else around the world. So this should not be a problem right? But as it turned out, things have not quite been so smooth for India. Let us now look at the details.
Foreign institutional investors have been a great source of dollar inflows for India. They invest in the India in order to capitalize on the higher interests on offer apart from trying to milk then security markets which features a number of high growth companies.
But, things have changed considerably. FII Inflows have dropped from US$30 billion in 2009-10 to US$18 billion in 20110-12. IN FY 13 also, FII have been net sellers, pulling out nearly US$327 million from the Indian Markets.
This has caused severe shortage of Dollars and has led to a freefall in the rupee. And given that these flows move in and out of the country frequently, this has caused major volatility in the Rupee. This is demonstrated by the fact that the Rupee went from being the worst performing currency in Asia to the best performing and back to worst in a span of 6 months from December 2011- June 2012 as the FII inflows poured in at the start of the year and have been withdrawn after the budget session.
Foreign Direct Investment was seen as critical to India’s development as the money was badly needed to build infrastructure in order to support economic growth. Thus the policies were liberalized and money came in. But, due to unfavorable government policies such as GAAR and failure of government to take tough decisions rolling back its decision to allow FDI in multi brand retail due to pressure from coalition parties, FDIs inflows have dipped recently to US$1.32 billion in May 2012 compared to US$4.66 billion a year ago. And this has had a direct impact on the rupee.
Balance of Payments is defined as a record of all transactions made between one particular country and all other countries during a specified period of time. One might argue that this fall must help exporters and reduce imports and that the situation will correct automatically. But what we fail to realize is that our imports are far greater than our exports and that the demand for oil is nearly inelastic due to the subsidies provided. It is precisely this imbalance between the current account and capital account in the current scenario has led to a Balance of Payments crisis.
What it simply means is that we are using up our foreign reserves rather than adding to it and it is going to be very difficult expect the RBI to intervene directly to stem the fall. This can be illustrated by the fact that our forex reserves fell US$12.8 billion Dollars in Q3 and US$5.7 billion Dollars in Q4 of FY12 respectively. RBI has used various measures such as limiting the banks open position in contracts and providing Dollars directly to the oil marketing companies.
But this has simply helped in reducing volatility, and has not prevented the Rupee from falling. Moreover, even though there have been more remittances, they have not been able to compensate for the outflows on current account and reduced inflows on the capital account. RBI just does not have enough firepower in order to do anything due to limited forex reserves.
The onus is on the government now to put its act together and stop using monetary policy to correct structural problems in an economy. Strong measures have to be taken on the fiscal policy front such as removing fuel subsidies and reducing fiscal deficit. Government needs to come out of its slumber and take decisive political decisions such as FDI in retail to attract Dollars and help recover. I know that increasing fuel prices would harm the economy, but I sincerely believe that Indian must bear the pain through this correction as this will result in a far superior recovery and will ensure that we will reach a solution rather than postpone the problem.