Macroeconomic environment calls for flexible currency movement
With global central banks battling persistent inflationary pressures, nurturing India’s domestic demand will require a fine balancing act, especially as global growth slows down. The foreign exchange reserves accumulated because of the ultra-loose global monetary policies are being utilised as the same global monetary policies now rapidly reverse. Recalling the impossible trinity, defending any levels of the exchange rate on a sustained basis, given the global context, could unduly impinge on monetary policy. Given an incomplete domestic growth recovery, a nascent credit growth cycle and an encouraging inflation outlook, letting the rupee adjust gradually could help reduce the burden on fiscal-monetary policies for calibrating both external (CAD/BOP) and internal (inflation/growth) balances.
On the external front, India’s merchandise exports registered a record high of nearly $430 billion in 2021-22. Global demand, driven by loose fiscal and monetary policies during the pandemic, was a prominent driver. India capitalised on this demand by marginally increasing its share in global exports through sharp growth in the exports of metal products, machinery, gems and jewellery, and textiles, among others. A part of the increase was also due to commodity price increases.
However, record-high exports were accompanied by record-high imports. The domestic demand recovery, along with a high energy import bill (coal, crude oil, and natural gas imports of $194 billion) pushed imports to around $620 billion in 2021-22. In addition, the impact of a recovery in domestic demand was visible in the sharp increases in imports of electronics and gems and jewellery along with elevated prices of edible oil. Overall, the trade deficit also registered a record high of around $190 billion.
The external sector pressures were kept at bay due to a combination of steadily improving services exports and steady capital inflows. The current account deficit stood at 1.2 per cent of GDP in 2021-22, after a surplus in 2020-21. RBI’s FX reserves rose by over $165 billion since the start of the pandemic, reaching a peak of $642 billion in September 2021. However, since then, the central bank has sold nearly $100 billion across spot and forward markets to defend the rupee.
The external environment has, after all, changed, especially since the Russia-Ukraine war. Global inflation, particularly in developed markets, has forced central banks to push interest rates higher and faster. Supply-side pressures now have an added headwind from a looming energy crisis arising out of the war. China, once seen as the fallback option in times of global slowdown, is faltering too.
There is little clarity on whether major central banks will be successful in engineering a soft landing. The US Fed is en route to pushing the policy rate to 4.5-4.75 per cent by early 2023. Amid a near-synchronised rate hike cycle, the US dollar continues to be on a strengthening path as the prospects for Europe, the UK, and other major trading partners remain bleak. The external sector is fraught with adverse risks for India, with a high probability of a recession in the US and EU even as it is uncertain how fast inflation will taper off; energy prices remaining hostage to geopolitical tensions and the possibility of divergence in energy prices and other commodity prices, and a slowdown in China (though it could be positive for commodity prices).
India is unlikely to be immune from these headwinds. Even as the global environment is turning, India’s domestic recovery has been relatively steady. However, in the past couple of months, the trade deficit has widened sharply. In addition, in the case of a prolonged global slowdown, service exports may be affected. If India’s growth remains ahead of the global average, the trade gap may not reduce substantially, especially if energy prices do not adjust. With continuing geopolitical tensions, erratic rainfall patterns and uncertain global growth prospects, commodity prices will remain risks for India in the near term, even though their recent softening bodes well.
Global monetary policy and geopolitics are also shifting into a different cycle than what investors have experienced in the past two-three decades. The period of relative geopolitical peace has also changed. China’s growth trajectory and the export of disinflationary impulses to the world are also shifting. These could imply that the cost of capital is possibly undergoing structural shifts. This, in turn, could imply a slowdown in capital flows. While India remains one of the most favoured destinations in comparison to its emerging market peers, the road ahead will be challenging in terms of attracting flows.
Since the beginning of the war, the rupee has depreciated by around 6 per cent against the dollar, much lower than major currencies. Real interest rate differentials stack up well for India, along with favourable growth differentials. Broadly, on a real effective exchange rate basis, the currency is fairly valued against a basket of its largest trade partners. The CAD, which could be around 3.5-4 per cent of GDP this year, may not be as alarming as it was in the taper tantrum period because of the size of the RBI’s FX reserves. Even at these elevated levels of imports, the import cover would be around nine months (as against six to seven months during the taper tantrum period).
The RBI seems to be in favour of using the FX reserves to gradually depreciate the rupee range in a lock-step manner, while the MPC is likely to increase the repo rate by 50 basis points in the September policy, with a terminal rate of around 6.25 per cent. Considering the current global macroeconomic environment, India’s policies need to be finely balanced, allowing for more flexible currency movements along with moderate monetary policy hikes.
The writer is senior economist, Kotak Institutional Equities