rock meets hard place

Why the Indian rupee is on a downward spiral and nobody knows how to stop it

June 20, 2013
June 20, 2013

The US Federal Reserve’s stimulus exit timeline shook the global economy. In India, the situation is particularly dire: its stock markets experienced the sharpest fall in almost two years, bond prices fell so much that trading had to be halted, and the value of the rupee fell to a record low. The rupee nearly reached the psychological barrier of 60 rupees to the dollar, a low point that many consider catastrophic for the Indian government.

Why? The chain of events goes like this. As the Fed’s quantitative easing program unwinds, the cost of US borrowing rises, causing massive outflows of foreign investment from India and less demand for rupees. The sharp decline of the rupee’s value comes at a time when India is struggling to tame high inflationspur economic growth and reduce its unwieldy deficits. A weaker rupee raises the cost of imported fuel and exacerbates inflation, which gives the central bank less leeway to cut interest rates to revive growth.  

Even so, the Indian government has said it stands ready to take action and stop the bleeding. But in reality, there’s not much it can do. Here’s why:

India’s foreign exchange reserves stand at $290 billion, which is barely enough to cover the cost of its imports for seven months. Attempting to vacuum up excess liquidity at the national level could halt business activity in local markets and cause a spike in money market interest rates. Those rates have already been rising because of fleeing foreign investment. Also, using central bank reserves to defend the rupee could attract the attention of currency speculators who are eager to bet on the currency’s fall.

The government could limit the purchase of gold and crude oil, but that would be unpopular and economically painful. India’s chief economic advisor Raghuram Rajan admitted that curbs and blanket bans would be “harmful.” He is advocating for broader reforms to liberalize and strengthen Indian capital markets, but those may be politically untenable.

In the meantime, companies and consumers will suffer. Corporations with large unhedged dollar holdings, such as telecom giants Bharti Airtel and Reliance Communications, will take on more debt in rupee terms. Firms with heavy raw material imports will face higher operating costs, according to Goldman Sachs. India’s largest automaker Maruti Suzuki is already considering sourcing more local products.

Some companies will foist rising costs on to customers. Computer makers like Dell and Lenovo and mobile phone manufacturers have already announced that prices will rise by around 10% in the coming days. The fall in the rupee has pushed up monthly household bills by 15-20% in the past month alone, according to a study by Associated Chambers of Commerce and Industry of India. If consumers pull back on spending as a result, the economy will really be in bind.

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