US recovery shows up India's vulnerability
A large part of the rupee’s sudden vulnerability is part of the greater strengthening of the dollar against most currencies. And that, driven by the US recovery, has reduced the differential between US and Indian bond rates, which is what is behind the outflows of $1.8 billion in FII debt over the past fortnight. As the US recovery gains ground, FII debt flows will either slow or even become negative, exposing the rupee to a greater potential shock. While the immediate impact will be to compress non-gold non-oil imports—these fell from $71.9 billion in Q4FY12 to $68.6 billion in Q4FY13—higher oil and gold imports could offset the fall. In BoP terms, with a CAD of $92 billion in FY13, of which just $23 billion was financed by FDI, this makes India a lot more exposed to volatile FII and other flows. It also has larger implications in terms of what it means for individual sectors. India Inc’s balance sheets take a hit of R15,000 crore for every one rupee fall in the value of the rupee to the dollar; it also causes a 30 paise hike in the under-recoveries on diesel—between March and now, a R2.5 fall in the rupee’s value has wiped out a significant part of the cut in diesel under-recoveries. A fall in the value of the rupee from 56 to 57, similarly, adds 20 bps to the pressure on WPI with a lag of 3 months.
While RBI clearly needs to intervene in the forward markets—data is available with a two-months lag, but in the past, it has helped—India needs to use this opportunity to fast-forward its reforms process. While raising FII debt ceilings to get more inflows has been an automatic response in the past, this merely postpones the problem and may not work at a time when US yields are hardening—in any case, when repayments and interest payments bunch up, as they have to given the short tenure of such loans, it adds to pressure on the rupee. While the list of such reforms is a long one, it is strange that despite trying to attract FDI in multi-brand retail, the government continues to make the entry conditions tougher. Despite the announcement made in the budget, there has been no progress in bringing in private sector coal miners in even a limited context; coal price pooling remains dead on the ground; despite the PMO’s intervention, Coal India’s supplies haven’t really improved. Despite several high-level representations—even state-owned ONGC has said it cannot explore for gas at the current $4.2 per mmBtu price—the government still hasn’t been able to make up its mind on raising prices. Though Fed Chairman Ben Bernanke’s promised winding down of bond purchases isn’t going to happen overnight—it is contingent upon US unemployment falling and events like the compulsory sequester will slow that process—India’s window of opportunity is certainly getting smaller.