India’s Currency and External Sector in Worrisome Zone

Some of the government's recent actions seem to suggest a lot of anxiety.

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A version of this article was first published on The India Cable – a premium newsletter from The Wire & Galileo Ideas – and has been republished here. To subscribe to The India Cable, click here.

The last few weeks saw the Reserve Bank of India (RBI) fight a losing battle to hold the exchange rate of the rupee as foreign portfolio investors (FPIs) kept selling in the stock markets. FPIs have sold shares of mostly blue chip Indian companies and taken out a whopping Rs 2.3 lakh crore (nearly $30 billion) from the Indian market since January. This has created severe downward pressure on the value of the rupee.

The rupee kept hitting new lows, falling below Rs 79 to a dollar, even as the RBI tried to stabilise the currency by selling dollars from India’s forex reserves. In one fortnight alone, the RBI expended $10 billion. India’s forex reserves are down $50 billion from its peak of $642 billion in October 2021.

India, being a huge importer of energy, further faces the prospect of a peak current account deficit (CAD) of 3.5% of GDP estimated by most analysts. In absolute terms, India is likely to have a CAD of over $100 billion. The challenge is to make up for this widening CAD with capital flows. This year, capital inflows (both FPI and FDI) are extremely weak. A lukewarm response to the LIC equity divestment also made it clear that foreign institutions are not showing interest in highly profitable Indian PSU assets.

Foreign investors will tend to hold their investment decision until the rupee’s decline/devaluation is fully done and a new equilibrium is found. What is the new level for the rupee post the Ukraine war, against the background of soaring energy and food prices globally? This is what most global investors are trying to fathom. Japanese investment research house Nomura is pegging India’s exchange rate at Rs 82 to a dollar. The finance ministry discreetly let it be known last week that Rs 80 to a dollar would seem reasonable given the global economic backdrop.

In an interview to CNBC, chief economic advisor Ananth Nageswaran admitted that India could see a negative balance of payments ranging from $30 to $40 billion in 2022-23. He quickly added this should not cause any alarm as such an amount can be drawn down from the forex reserves. There is another somewhat alarming report in the Economic Times based on RBI data that $267 billion of India’s external debt is due for repayment in the next nine months. This constitutes roughly 44% of India’s forex reserves. Could this become another vulnerability under conditions of global monetary tightening?

Also read: Soaring Crude Oil Prices Are Pummelling the Rupee. When Will the Pain Stop?

While Nageswaran argues there should be no cause for alarm, some of the government’s actions seem to suggest a lot of anxiety.

The finance ministry last week imposed a heavy windfall tax – of nearly $40 a barrel – on domestic crude producers like ONGC and Oil India Ltd. It also put a reasonable export tax of Rs 13 per litre of diesel, petrol and ATF exported. This mostly affects Reliance Industries which exports over 90% of its refined products. RIL was making super profits for several months as it imported much cheaper, discounted Russian crude and simply exported products, mainly diesel, to the EU and US. According to some experts, RIL was making a profit of over $35 a barrel. As per JP Morgan, the profit margin may come down by $12 to $13 per barrel after the government imposed the export tax. RIL still makes a healthy profit on its exports.

The government also imposed a higher duty on gold imports in the hope of reducing imports and saving precious foreign exchange.

The problem is these are just piecemeal decisions aimed at controlling the CAD. Some of the moves, like imposing export curbs on food, steel and oil, are aimed at controlling domestic inflation but also end up reducing export earnings at a time when external sector vulnerability is growing. So between controlling domestic inflation and stabilising the external sector, the Centre is left with a Hobson’s choice. This is precisely why macroeconomic management of contradictory forces is not easy at all. The more tinkering and tweaking governments do at the micro policy level, the task of macro management becomes that much more uncertain and difficult. This is what is happening in India now.

The money raised through the tax on windfall gains of oil companies will partially help to meet the growing fiscal deficit gap. But this is just not enough because overall excess expenditure beyond what is budgeted may touch Rs 3.5 to 4 lakh crore even after all the windfall taxes levied by the government are factored in. The growing fiscal challenge in the midst of worsening global economic conditions cannot be underestimated.

Also read: Why the Recent Massive Outflow of Capital Matters for India

Prime Minister Narendra Modi’s promise of more comprehensive welfarism via generous labharti programmes also add to fiscal pressures as India moves from one election to another with more welfare commitments against the backdrop of dismal employment prospects.

At a macro level, the world will be watching closely how India handles its twin deficits – fiscal deficit and CAD. Eventually the macro management of these two parameters will determine the stability of the exchange rate, inflation and growth. Short term tinkering won’t help beyond a point.