Domestic Bonds

No Matter How Dollar Strengthens, a Plunging Rupee Destroys National Macroeconomic Stability

The Indian rupee is at 82.7 to the dollar, rebounding from a record low of 83 on October 20, amid reports that the Reserve Bank of India has resumed selling dollars through banks to support the national currency, adding to the more than $100 billion. sold from the central bank’s foreign exchange reserves this year.

Yet efforts to support the currency failed to significantly prevent it from hovering near all-time lows amid a dovish RBI pivot, soaring inflation and trade imbalances.

RBI policymakers have signaled that the central bank will pause its hiking trajectory at its next meeting as growth concerns are expected to take priority, despite stubbornly high inflation.

Source: Trade Economics

The latest data showed retail prices rose 7.4% a year, marking the ninth month in a row that inflation exceeded the central bank’s upper target of 6%.

While the RBI has raised its key repo rate by 190 basis points (bps) this year, continuing a path of monetary tightening, rate hikes have been much slower than those of the US Federal Reserve. (A basis point is one hundredth of 1 percentage point.)

Performance of the Indian Rupee over the last 10 years. Source: Trade Economics

Offshoots of a weaker rupee

1. Soaring Inflation: An ‘Invisible Tax’ for India’s Vulnerable Consumers

India’s annual inflation rate hit a five-month high of 7.41% in September from 7% in August, above market forecast of 7.3%. Prices increased more rapidly for foodstuffs (8.6% against 7.62% in August), vegetables (18.05%), spices (16.88%), cereals and derived products (11 .53%) registering the largest increase as erratic rainfall affected local crops and the supply shock of the Russian invasion of Ukraine remained.

Housing prices (4.57% vs. 4.06%); education (5.68% vs. 5.51%); transport and communication (5.39% against 5.2%); and health (5.52% vs. 5.43%) also accelerated.

On the other hand, the cost of fuel and lighting increased at a slightly slower rate (10.39% vs. 10.78%), but still quite high. Compared to the previous month, consumer prices increased by 0.57%.

A fall, or depreciation, of the rupee will only further weaken consumers’ purchasing power in a festive period that typically sees a spending boom.

Prices for most consumer goods and services (and equipment) are already high and will likely remain so over the next year. Wholesale price inflation has remained in double digits for over a year now.

The stubbornly high inflationary trend was catalyzed by external factors, but it is also driven by vital internal factors. There are forces on the consumer demand side, led by the top 5%, and an asymmetric and disproportionate inequality-driven trade recovery that has made prices even more volatile.

This is once again a vindication of an earlier forecast from June 2021, when several pundits commented on the likely permanence of higher inflationary trends.

However, the ruthless indifference to controlling inflation, manifested by the RBI’s mismanagement of monetary policy, will act as a higher “invisible tax” – and cost – for the poor and vulnerable at the grassroots level. India’s deeply stratified consumer base.

We are already seeing that the invisible “tax” of inflation affects two-thirds of India’s rural consumers in the worst possible way.

Low and lower middle income households drive overall consumption in India, meaning that 66% of all consumption comes from them. All of the income growth concentrated in the top decile in recent years has further dampened the largest component of GDP growth. And inequality is not just a social problem, but a huge economic problem.

The double whammy of falling employment and COVID-19 has now resulted in a significant reduction in consumption by low- and lower-middle-income households – who are contracting essential spending, delaying discretionary spending and reducing spending between categories. It has also led to a delayed recovery in many key consumer sources – autos, high-value durable goods, out-of-home spending and discretionary spending like retail, restaurants and personal care.

2. Dwindling foreign exchange reserves make India more vulnerable to capital flight

In India, foreign exchange reserves are the foreign assets, in the form of gold or currency, held or controlled by the central bank of the country. Reserves may also include special drawing rights and marketable securities denominated in foreign currencies such as treasury bills, government bonds, corporate bonds and shares, and foreign currency loans.

India’s foreign exchange reserves have remained adequate for much of the period since 2000 due to a larger inflow of foreign capital. However, the Rupee’s collapse is now making India’s strong currency position a bit wobbly. The economy’s foreign reserves have fallen by $110 billion since September 2021, when they hit a record high of $642.45 billion.

Source: Trade Economics

The RBI has embarked on a dollar spending spree to stabilize the exchange rate. Still, the results have been mixed. The rupee should touch 85 per dollar by the end of the year if the current trend continues.

External factors aggravate the trend. Aggressive monetary tightening by the Federal Reserve will only accentuate capital outflows – further strengthening of the US dollar, which has triggered a withdrawal of portfolio investment from foreign investors.

Simply put, a higher interest rate from the US regime will incentivize investors to take their money out of countries like India and invest it in the US for a higher return on accrued interest.

That said, our over-reliance on foreign capital (via foreign portfolio investment and foreign direct investment) to fill the domestic savings and investment gap in the economy, in a context of weak domestic private investment and inadequate capacity utilization, has structurally made India’s economy more vulnerable to these exogenous (external) shocks.

Any drastic change in the exchange rate will continue to affect the state of the economy more than it ever has.

3. Rising current account deficit and trade imbalances

Source: Trade Economics

India’s trade deficit was revised to $25.71 billion in September from a preliminary estimate of $28.72 billion and $22.47 billion a year earlier. Imports jumped 8.7% year-on-year to $61.16 billion amid rising commodity prices, while exports grew more slowly by 4.9% to $35.45 billion of dollars.

The overall current account deficit has started to widen after the sharp surge from the weakening rupee (see table above). As far as trade is concerned, Indian imports are still heavily dependent on China, even though, according to the data, the United States became India’s largest trading partner last year.

Source: Trade Economics

In the period 2021-2022 alone, trade between India and China totaled $115.42 billion, compared to $86.4 billion in 2020-21. Most of this trade takes the form of increased imports from the Chinese.

Therefore, it is essential to consider the effects of soaring inflation amid a weaker rupee in the context of other macro-micro realities.

Furthermore, the overall job creation rate in India has been low (see CMIE data); domestic private investment has remained weak (see figures on gross fixed capital formation); consumer demand has not increased across all income brackets (see recent consumer spending and consumer sentiment survey results).

My most important concern here relates to trends in domestic unemployment and private consumption. Personal consumption has long been the main component of India’s GDP and a continuous strong driver of GDP growth. Its contraction as a percentage of GDP of 300 basis points over the past three years (from 60.5% in 2019-20 to 57.5% in 2021-22) was already known, and it is at this problem that needed to be addressed in an urgent and targeted manner.

Alas, this was not resolved by any fiscal intervention on the demand side. The impact of the global downturn over the past three years is made even more urgent by the sharp slowdown in rural consumption over the past six to nine months.

All of these trends, viewed in the collective order of their cumulative impact on the economy, reflect a “devastating” effect of the falling rupee on India’s domestic macroeconomic stability. Immediate interventions for a medium to long term schedule are necessary, but who is listening.

Deepanshu Mohan is Associate Professor of Economics and Director of the Center for New Economic Studies (CNES), Jindal School of Liberal Arts and Humanities, OP Jindal Global University.