Indranil Sengupta, chief economist with Bank of America Merrill Lynch, believes the Reserve Bank of India (RBI) should use the current strength of the rupee to shore up foreign exchange reserves. Given how linked to the global economy India is and how fickle foreign flows can be, he suggests it might be in the interests of the economy to let the currency depreciate in the near term and enjoy the benefits of a sustainable appreciation once the reserves have stabilised to levels of around 10 months of import cover. In a conversation with Shobhana Subramanian, Sengupta observes that while there is no doubt a big fiscal cost to holding dollar assets?the cost of RBI buying $80 billion in the next two years could be $4 billion or 0.2% of GDP annually?the price of not doing this would be constant volatility, uncertainty and fear.
Where do you see the rupee headed?
Our view is that the rupee will trade in the range of 58-62 to the dollar and much will depend on where the dollar goes. Currently, it?s close to 1.37 against the euro and our house view is that it could strengthen to 1.3 by December. In India, gold import curbs have to go sometime and RBI clearly needs to buy dollars since forex reserves, at 7.5-8 months of import cover, are at a 16-year low and at half the level they were in 2008. RBI has made it clear it wants to build reserves but we need to wait and see what the new government wants.
What is your view on what the government should do?
In 2009, after the UPA-2 came to office, we saw RBI letting the rupee appreciate and you ended up halving the import cover. In contrast, then RBI Governor Bimal Jalan doubled the import cover between the earlier BJP years of 1998 and 2004, which led to a sustainable appreciation. If you have the patience, you will finally end up with the currency at 56. But if you rush to 56 with only a 7.5-8 month import cover, then there could be a problem later. We must remember the world today is very volatile. Also, even to maintain the reserves at an eight month cover, RBI will need to buy $80 billion over the next two years.
What could be the source of volatility?
The fact is that there is a tapering going on and liquidity all over the world is coming down. Since 2009, a third of the flows to EMs have come to India so it?s not as if all future flows will be much higher. From that perspective, global liquidity is shrinking and so you need to build forex reserves. It?s just like having an army. We have seen the havoc that can be caused if we don?t have enough of a buffer and given that GDP is growing at a nominal 10-15%, as are imports, if you don?t build forex reserves, we will fall short. Other BRICS nations like Russia and Brazil continue to have high reserves.
One reason why a stronger rupee seems to be preferred is that imported inflation comes down, oil subsidies are smaller?
I agree with that. The question is can you get that 56 on a sustainable basis now or is it better not to rush there but get it later. You don?t have forex reserves but you want appreciation. We?ve seen in the past that the rupee tends to shoot up to the previous high; we went to 54, then back to 48, falling to 57 before rising to 52 and then falling again, to 68. Also, now that we?ve picked up $34 billion from FCNR(B) bonds, apart from listing Indian G-Secs in an EM bond index which could fetch us $20-25 billion, there aren?t too many options. Once you build reserves, appreciation will follow. If you don?t have strong reserves, the rupee will only become cheaper because once the import cover starts falling, the rupee won?t appreciate. That is the mistake the Congress made and when the crisis broke, we didn?t have the necessary dollars to sell?
There is the argument that if we buy dollars, the rupee will go to 60?
I think the choice is between having the rupee at 60 for some time and enjoying the benefits of appreciation over time or trying to appreciate now and landing up in a big mess later. The export angle is important, that is why RBI Governor Raghuram Rajan has been saying a level of 55 is too strong.
Right now, everything is in favour of the rupee, especially with the strong mandate that the government has won. But this could go away since curbs on gold imports can?t continue beyond a point and the dollar may appreciate. Also, the kind of flows you are seeing because of the BJP?s strong mandate won?t continue month after month. Again, there are no foreign exchange repayments due for six months but that will begin to reverse in October-March. So, we need to build forex reserves. Come to think of it, should the country have been in the mess that it was in July 2013?
What could be the reasoning behind keeping the rupee strong?
Once you let the rupee appreciate, it gives foreign investors more confidence?because they get rupee-gains, they tend to invest more. However, that can be dangerous because one day when the market realises that there are no forex reserves, investors will rush to the exit. It?s easy to get carried away by all this but foreign investors will also keep track of the reserves. In 1997, FII investments were 30% of forex reserves; today, we have an eight-month forex cover but FII investments are 80% of the reserves. Even if a small amount, say $1 billion, is pulled out, there is pain and that makes us more vulnerable. Right now, RBI seems to be defending 58.50, so if you are patient for some years, the benefits will follow.
Do exports get badly hit at 58?
Not really, because the impact of the rupee on exports takes at least three to five years to play out. In fact, the rupee has played virtually no role in the improvement in exports over the last 10-15 years; most of the increase has happened because of higher oil exports and auto ancillaries exports. Customers don?t really change suppliers purely for a small difference in the price; the relationships tend to be stable. Of course, India has always preferred a cheap currency.
What kind of foreign inflows are you building in for FY15 and FY16?
We are pencilling in combined inflows into the bond and equity markets of $25 billion in FY15 and $30 billion in FY16. As tapering happens, there may be a rotation from bonds to equities.
What is the fiscal cost of buying dollars?
There is no doubt a big fiscal cost but that cost is far higher if the rupee depreciates. If RBI holds domestic assets, it earns 7-8%, but on dollars the return is at most 2%. Clearly, the cost of holding foreign exchange right now is very high given the interest rate differential between India and the developed world. For instance, the cost, for RBI, of buying $80 billion in the next two years could be $4 billion or 0.2% of GDP annually. But the cost of not doing this will be constant volatility and fear and it?s possible the country could once again end up in a situation where RBI may not be able to defend the currency.
