In a dramatically evolving situation rarely seen in the world of economic policymaking, RBI has come back in a big way to defend the rupee, whatever the cost. In light of the visible compromise of monetary independence and resulting liquidity tightening stance doing little to shore up the beleaguered currency, policy activism has now resorted to capital controls.
RBI is making attempts to raise capital flows and hinder outflows. Now that strong US yields seem to be largely structural in nature and the Indian policy-making seeking to arrest the rupee's free-fall, there are clear indications of compromising the monetary stance (involving further monetary tightening) and imposition of fresh capital controls (not ruled out now).
Until the latest move, the policy was essentially moving between pegged exchange rate (a floor on the INR) and an independent monetary policy in view of a largely open capital account on the standard trilemma. However, the latest set of capital controls indicates desperate willingness to compromise every standard and established revisionist view on economic policymaking. The question that arises thus; can these moves really have an impact, even on a short-term basis. The answer is a big no, for a set of reasons.
First, real rates matter. And this matter adjusted to CPI, the inflation people of India face. CPI adjusted real rates are negative in India for three years. But RBI feared missing the bus on growth. Monetary policy turned aggressive in cutting rates even as no visibility had emerged on either CPI inflation or the current account deficit. Indeed, a negative real interest rate and a rigid current account funded by volatile capital flows drived the undercurrent against rupee, exposing it to the externalities of rising US realty rates and strength of the dollar. The fact that all EMEs' currencies are facing depreciation against USD can't take away the concern that this sharp depreciation in rupee does have roots in the fundamental concerns on the economy.
This brings us to the second reason why the root cause is yet to be acknowledged and diagnosed. The undercurrent of an unsustainable and rigid CAD on rupee is a common knowledge but what has clearly been missed is the drivers behind this huge deficit. Consensus cries hoarse citing the unproductive gold imports as the real culprit, leading to a lot of import restriction on the yellow metal. But, isn't gold being made a scapegoat?
Despite having nearly 10 per cent of the world's coal reserves, domestic coal production has been scarce enough to meet the requirements of thermal power plants across India, thus driving its large-scale import, more than two-fold rise in the past five years. Similar policy bottlenecks have led to sharp rise in fertilizers and scrap metals. The virtually dead mining sector resulted in a sharp fall of iron ore export, from $6 billion to a meager $1.5 billion. Together, the deficit out of all this has run into $22-37-38 billion for three successive years starting FY11 to FY13, the latest data constituting 43 per cent of corresponding annual CAD.
In addition, ill-conceived oil subsidy and inefficiency of the power sector have largely led to dieselization of the economy, resulting in an unprecedented rise in oil imports even as the general business cycle slowed down significantly. As such, a high CAD that has increasingly shown inelastic tendency to INR movements is quite natural.
The third fundamental reason behind rupee weakness is the sharp fall in overall productivity in the economy. The benchmark indicator, ICOR (incremental capital-output ratio) has seen a drastic fall over the past couple of years.The reasons are not far to seek with the humungous amount of capex lying idle at various level of implementation for sheer lack of policy drivers and funding, thereby making capital significantly less productive. Meanwhile, generic lack of competitiveness in India's exports has also meant that economy failed to exploit the large currency depreciation on the external front.
