Rupee's Fall and RBI's Tattered Safety Net

Rupee’s value is going down. Why? Let’s take classic demand and supply formula!

Rupee’s value is going down. Why? Because India’s Current Account Deficit is widening, it’s no more a prosperous investment-destination, Foreign Institutional Investors aren’t investing, whosoever have invested are moving out, speculative trading adds false pressure on rupee and the most  cited reason, Fed Chief Ben Bernanke intends to taper-off monetary-easing from US economy. Seems all Greek and Latin? Too much to dissuade you to understand rupee-economics? Be brave! Read on!

Let’s take classic demand and supply formula! At any given time if the demand of dollar is more than that of rupee, it creates dollar-scarcity and rupee-liquidity. Less is always expensive, plenty is cheap. That is why rupee depreciates i.e. you pay more in rupee against one dollar.

Now, who all are demanding dollar? Where do we need it?

1)    People like you and me have to pay in dollars for all our imported tech gadgets, luxury items, foreign education etc.

2)    India’s huge import business demands dollars. Importers have to be paid in dollars.

3)    Investors willing to invest abroad need dollars.

4)    To maintain country’s Foreign Exchange Reserves, dollar is needed

5)    To pay foreign debts incurred by corporate and Govt., dollar is needed

Who all are demanding rupee?

1)    Rupee is needed everywhere in domestic economy. In banks, households, companies etc.

2)    Foreign investors willing to invest in India

3)    Indian Exporters

4)    Opportunists ogle on rupee for speculative trading.

Why demand of dollars surpasses that of rupee?

Indian is an import-driven country. 80% of our oil demand and 100% of our gold demand is met through imports which are the largest two imports of India. For some reasons, indigenously produced materials and products like wheat, rice, coal etc. are also imported in the country. Given that India’s export business is bleak, dollar outflow is always more than its inflow. In the parlance of economics, this imbalance i.e. the difference between total imported and exported goods, services and transfers is known as Current Account Deficit (CAD). India’s CAD is currently 4.8% of GDP. So the logic is, as long as India’s import dependence doesn’t get controlled i.e. its CAD doesn’t go down, rupee’s value will remain volatile.

Now that you are aware with the sources of rupee and dollar demand and also know the most significant reason affecting rupee, let’s come to why sudden downfall in INR, why sudden fuss around it?

In the aftermath of global recession in 2009, in order to boost American Economy, American Federal Reserve Chief Ben Bernanke went for monetary-easing i.e. good chunk of dollars were minted and made available to Americans on zero or negligible interest rates. American investors invested their cheaply acquired funds in various countries and made profits thanks to higher interest rates in those countries. In India many foreign investors invested their money in Govt. securities and debt market and acquired gains through interest rates provided on securities and stocks. Investment by them is known as Foreign Institutional Investment. Recently Fed Chief announced that he will taper-off monetary easing i.e. no more cheap money will be available to American investors. Interest rates will rise. In that case they will have to pay interest in their own country. If gained interest in other countries is meager or less than the paid-interest in their own country, no point for them to invest abroad.  Differential between interest rates either leads to arbitrage advantage or arbitrage loss. FIIs are moving out of India after this announcement because they are wary of arbitrage loss. Foreign investors obviously moved out with funds in dollars, steep scarcity of dollar suddenly emerged and caused rupee to fall.

Now let’s understand what RBI is doing to perk up Rupee:

If rupee is to be strengthened, dollar-demand has to be reduced. Dollar-demand by foreign investors cannot be controlled by RBI, dollar-demand for import business cannot be reduced so easily, dollar-demand by consumers or corporate is also somewhat out of control of RBI and dollar needed for Forex can also be not compromised. That said, RBI can only control speculative trading creating false demand of dollar.

What is speculative trading in currency market and how does it affect rupee?

In currency market, predictions are made as to how much rupee will fall or gain against dollar. Sensing the market sentiment, investors rather speculators invest in the currency which wins them profit. Needless to say they sell rupee in order to buy dollars. As good number of these opportunist speculators seeks loans from banks to convert rupee in dollar, it unnecessarily boosts rupee liquidity and creates shadow dollar-demand.

Conclusion: Though RBI took few measures to suck this liquidity out of the banking system so that banks cannot easily lend but given that rupee is still hovering around above 60, RBI has to admit its measures have been failed in its core objective i.e. to strengthen rupee. On the other hand collateral damage of increasing lending rates is all set to dampen the growth prospect of the country which is already running slow.

INR 60-61 against dollar is perhaps the new normal which cannot be reduced as long as the major cause of its weakness i.e. import dependence isn’t reduced. To surmise, excessive dollar demand can only be curtailed through internal sustenance i.e. self-sustained economy at an optimum level can only protect currency.

Super regulator : Greater contention

Just because Govt. doesn’t enjoy autonomy in financial matters, it intends to dominate the sector through Financial Code Bill 2013

India is toying with  an idea of super regulator for burgeoning financial sector amid spate of incongruous standpoints of financial regulations. The new Financial Code Bill proposes to create a unified financial regulator merging rest of other regulators  barring RBI, though  very purpose of bringing it to the fore remains unclear. The report of Financial Sector Legislative Reforms Commission headed by Justice B N Srikrishna, has already generated a hectic debate as it waters down RBI’s powers and wets financial regulation in one super notch bureaucracy.  There are valid apprehensions that sole regulator may suffocate financial sector with confusions and turf wars amidst complex nature of financial products and services. Having multiple regulators for varied financial services is a global practice, willing to do away with it is like returning to square one.

Under the proposed regulatory architecture, there will only be two regulators i.e. RBI and a Unified Financial Agency which will merge the existing capital markets, insurance, pension fund and forward markets regulators (Securities and Exchange Board of India, or Sebi; Insurance Regulatory and Development Authority, or Irda; Pension Fund Regulatory and Development Authority, or PFRDA; and the Forward Markets Commission). There has to be different regulatory bodies for capital markets, commodity markets, insurance and banks. Govt. must make it very clear what purpose a super regulator would serve when having at least three apex monitoring authorities in financial sector is a common practice. While IRDA and PFRDA can be merged into one but merging all four is not only irrelevant but unwise.

A closer study of the Financial Bill suggests that it implicitly focuses on pruning RBI’s powers perhaps because RBI hardly designs its policies the way Govt. wishes it to. According to new Financial Code there will be an empowered Monetary Policy Committee which will be though headed by Chief of central bank but five of its seven members will be outsiders. The finance ministry will also send a representative, but without a vote. That means the majority of members will come from outside the RBI and they will be appointed by the government. MPC is a welcome move but the current structure seemingly aims at diluting RBI Governor’s control over monetary policy who can override MPC only in exceptional circumstances.

Non Banking Financial Institutions and Housing Finance Companies have also been kept outside RBI’s ambit which is certainly insignificant as the functions of NBFCs and HFCs are no different from banking institutions, therefore, having different regulator for former and latter is utterly illogical.  RBI will also no longer be Govt’s debt manager and a new body i.e. Public Debt Management Agency will take over this job of raising loans for the government. Even on capital controls, FSLRC has proposed that all issues related to inflows be handled by the government, while RBI should deal with outflows. It also recommends empowering the existing Financial Stability and Development Council, which would be headed by Finance Ministry and not RBI.

The only positive proposal seems to be coming out of this bill is that it specifically addresses issues related to consumer protection. There will be a common Financial Redressal Agency which will handle all type of consumer complaints from bank deposits to exotic derivative products. It will thus spare consumers to go through the varied complex system of grievance registration and redressal for diverse financial services.

FSLRC recommendations have come in the wake of a spate of disagreements between the central bank and the finance ministry over the past decade. Just because Govt. doesn’t enjoy autonomy in financial matters, it intends to dominate the sector through this legislation. Financial policies must be governed by an institution independent of Govt. control as it is now. To encroach upon RBI’s authority will only increase further governance problem. Govt. would do well to first contemplate likely repercussions what such a contentious step can bring before moving towards its implementation.

Creaky Consensus

Genuine doubts on success of GST are still looming large as consensus on the introduction of the same appears loose and creaky.

After a long and arduous test of central government’s persuasive skills, states have finally agreed to the introduction of the long awaited Goods and Services Tax (GST). Decks have been cleared for the nationwide roll-out of GST in 2014 albeit by the new government after general elections. Genuine doubts on success of GST are still looming large despite a broad agreement with states on the contours of GST. Value Added Tax (VAT) experience coming  handy to this apprehension. All the hoopla created around  (VAT) has been fizzled out just in few years due to the over tinkering of VAT rates by the states. This has   defeated  the very purpose of harmonized taxation system for goods across the states.  

GST being at second level after VAT is more comprehensive in nature. It, as the name suggests, will be applicable to goods and services both and will replace litany of indirect taxes at state as well as at central level. Taxing services which yet falls in Central Govt. territory will come in the purview of state Govt in a limited manner. Although political reverberations on this radical tax hint that even if it is implemented, it may face the same fate as VAT did.

Indirect taxes, levied on the consumption goods are quite heterogeneous. Taxes like excise duty, custom duty, services tax, Central sales tax  are put by the central Govt while VAT/sales tax, Octroi are levied by the state govts. Rates of state level indirect taxes are varied in various states leading to incongruity and confusion for producers and consumers. As India is going to adopt dual GST i.e. the combination of Central Goods and Services Tax (CGST) and State Goods and Services Tax (SGST), it has potential to set aside these several central and state level indirect taxes by mere a single tax. CGST will subsume excise duty, services tax and additional duties of custom while SGST will substitute VAT/sales tax, octroi,state surcharges etc. This SGST rate is supposed to be uniform across the states. Uniform GST will help reduce inflation as common tax regime can take off the demand pressures from the market, a fact endorsed by RBI deputy Governor Sudhir Gokharan.

Another characteristic of GST is that it is a destination/consumption based tax i.e. it will be charged only on value added at every single stage of production. The tax on value addition is ensured through a tax credit mechanism throughout the supply chain. GST paid on the procurement of goods and services is available for set-off against the GST payable on the supply of goods or services. The idea is that the final consumer will bear the GST charged to him by the last person in the supply chain. This mechanism of GST has instilled a sense of excitement among industries which have gone wary of giving plethora of taxes to plethora of departments. Consumers will also be benefited as industries will pass on their profit to consumers in the long run by lowering down prices.

It is true that no ideal tax model can be fitted in all countries but any internationally-experimented model, if adopted, must not be tampered with to the extent that the real purpose of the same loses its value. That is exactly what happened with VAT and is happening with GST model in India. Brinkmanship of state politicos has neither let survive any tax reform in India before, nor would it now. The fact that GST will restrict the power of state govt. to levy additional discretionary taxes and that no state will like its state exchequer get totally dependent on central bounties, they will try their best to deviate themselves from it. The adhocism of taxation structure is the real cause of worry as state Govts have not yet subscribed the fact that a stable tax regime is a must for growth. Consensus on introduction of GST appears creaky and loose. Hence, at central level GST might work but the fate is uncertain for states. if GST could be implemented homogeneously across the states keeping in view the revenue-neutral rates for them, it is well and good, otherwise trampled GST, the one in discussion right now will take it nowhere but VAT way. 

A Glittering Risk

Gold must not glisten so much so that it makes Indian economy lose its already fading shine. Rising inclination towards gold investment among Indian populace is a cause of serious trouble for the country. It is one of the potential factors behind ballooning current account deficit, which has widened to an all time high of $22.3 billion, or 5.4% of gross domestic product, in the July-September quarter. Current account deficit (CAD) is measured by the difference between a country's exports of goods, services and transfers and total imports within a time period.

Reserve Bank of India, in its recent Financial Stability Report, showed concern over increasing gold imports. As per its draft report “Gold imports have continued to be high and have accounted for, on an average, over two-thirds of the CAD during the last three years. While India’s share in international trade is less than 2 per cent and that in world GDP is less than 6 per cent in Purchasing Power Parity terms, it accounts for a quarter of world demand for gold.”

The investment sentiment in the economy is at its all time low. High inflation is robbing returns on bank savings while mutual funds and equity are not offering attractive returns either. Gold seems to be the safest option for people to invest their hard-earned money. It is a global phenomenon as people tend to go for gold because it provides them a sure hedge against growing inflation and in an insecure economic environment. Only difference is that their gold trading is paper-based unlike ours. Recently SBI proposed an idea of virtual trading of gold instead that of physical. Gold-linked financial instruments, gold bonds etc must be introduced which yield similar returns as this yellow metal does in physical form. Such paper based gold trading might reduce the problem of physical possession of gold which leads to higher import of gold.

According to the most recent available data from the World Gold Council, India's gold demand during the January-September period of 2012 was 607.6 metric tons, down 24% from a year earlier. It could happen because Govt. had doubled the customs duty on standard gold bars to 4%, and non-standard gold bars was doubled to 10%. But a closer data study reveals that gold imports did fall to 131 tons in the April-June quarter but again rose 9% to 223.1 tons in the July-September quarter. A sharp recovery in Q3 is also likely due to peak festival and wedding season buying. Hence Govt. effort of increasing import duties on gold in the current fiscal year, eventually, bore no fruits.  Yet Finance Minister P. Chidambaram again intends to resort to making gold imports costlier. He must also keep in mind that expensive retail price of gold might lead to smuggling of the same. Govt has also asked gold import agencies such as MMTC and STC to lower the volume and value of gold imports.

Gold loans disbursed by banks and other Non Banking Financial Companies (NBFCs) pose a threat to financial stability of banks in India. They lend borrowed cash from banks to people in exchange of gold. RBI says that the bank-debt of these gold-loans companies have increased by 200% over the period of one year. Indian banks will be in trouble if ever NBFCs falter in the wake of volatility in gold price. As per RBI guidelines, these companies can only provide 60% of loan against the value of collateral gold.

Predictions are against any betterment of economic condition in year 2013. This negative sentiment will buttress the trend of gold investment further because real profit through any other savings policies is meager given lower interest rates and inflation. Govt. must understand that bumping up import duties on gold import is not a solution. He would do well if he tries to drift people’s attention away from this yellow metal by offering equally valuable financial products and inflation-indexed policies. Higher gold import is actually not the only problem. Recycling of gold scrap, huge stock of idle gold which is highest in the country and gold-smuggling are few other challenges needing immediate concern. It’s high time that Govt. pursues a viable gold policy. 

If inflation……!!

Inflation is all set to become the single most significant number for Indian economy in coming three months. The consumer spending, interest rate, overall economic growth and trend of investment will anchor on the inflation data of weeks to come. With the ensuing festive season, the shopping spree of Indian consumers will be guided by the level of retail prices and companies smartness to woo them despite pressure on margins.  While RBI will keep a hawk eye on inflation and take the future course about interest rates for the busy season of bank credit. Consumer spending will be an indicator of demand while interest rates will be a pointer for the status of industrial investments during the second half of the current fiscal.

India’s shopping season is all set to begin as winter festivals are setting in. Marketers are keeping fingers crossed as inflation has already spoiled the shopping party. For the first time customers are not showered with the offers which they were habitual of during this season. This is probably the first festive season when almost all of the automobile, home-appliance or electronics companies have increased the prices to factor in the increased costs of production, energy and borrowings. Food basket of consumers is already costly with the ever rising prices of wheat flour biscuits, sugar and oil.

Indians may not spend much during this festival season owing to the high inflation in the country, according to the 'Mood of the Nation Survey' conducted by global research firm IPSOS. A newspaper reports state that more than a third (78%) Indians claimed that their planned expenditure during this festival season was less than Rs 10,000. Among the respondents, about 43% individuals said that their spend during this Diwali was less than Rs 5,000. These people were mostly from middle and lower middle income families. The IPSOS survey was conducted between September 24-27, 2012 among the men and women in Delhi, Mumbai, Kolkata, Chennai, Bangalore and Lucknow.

Meek festival demand is significantly risky for the economy. Companies won’t be motivated enough to start fresh investment for the enhancement of their capacities in a timid demand scenario.  Hence if inflation is not checked, less shopping by consumers will add woes to the economic downturn.

Indian industry is crying for low interest rate on bank borrowings.  Reduction in interest rates is directly related to reduction in the level of inflation. India's annual consumer price inflation (CPI) fell in September to 9.73% from 10.03% in August, driven by a marginal fall in fuel and food prices. But it is still high on Reserve Bank of India’s parameters to reduce interest rates. In the last policy meeting RBI remained hawkish on the stance as the WPI refused to budge below 7%, the RBI’s comfort zone. Indian interest rates are the highest among the major economies .With the pass-through of diesel price likely to take effect soon, CPI inflation would head back to double digits in the next month. Inflation data will shape up the RBI's policy review, scheduled on October 30. RBI’s stance towards interest rates will set the tone for fresh investment by private companies in the economy.

Global oil prices will be the key detriment for the inflation in coming months. Global commodity prices will also be cardinal for the behavior of inflation in Indian market. Although an unprecedented fall in the growth of China is a bad news for global economy but it will still help reduce the crude and commodity prices.  A renewed strength of Indian Rupee is likely to help in keeping imports cheaper and inflation under control.

The stubbornly high Inflation is one of the major factors behind the India’s latest economic hardships. It is now going to be crucial policy guide for the government’s renewed efforts to rehabilitate economy. Pick up in the demand and cheap credit is must to bring back the feel good factor among investors and industry.  This is the most opportune time for government to take inflation control as supreme ‘reform agenda’ for the good of the economy in general and aam adami in particular.

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