Indian rupee: Vulnerable as ever

Nov 11 2013, 20:04 IST
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SummaryIndian rupee: Policy focus has to shift from funding the CAD to reducing it on a permanent basis

The journey of Indian rupee (INR) against the US dollar (USD) can be traced back to the pre-Independence days when INR was at par with USD. After Independence, India chose a fixed rate currency regime with the currency pegged against GBP. However, with the passage of time and change in circumstances the pegs were modified.

In 66 years of Independence INR has depreciated 66 times against the USD (till end-August 2013). In the past five years, the rupee has depreciated by a huge 60%.

The vulnerability is especially evident with the onset of the new century. In 2003-2007, INR appreciated about 20% from 50/USD to 40. The caveat was that USD depreciated about 40% against the Euro, 35% against the Swiss franc and 25% against GBP. So against a basket of top three currencies, INR did not appreciate at all or rather depreciated. When the financial crisis hit the global economy INR depreciated 25% in 2008 alone to touch 50/USD. Again after a three-year consolidation, INR shot up to 68/USD (30% depreciation) in May-August 2013 as the talks of Fed taper gained ground.

This vulnerability owes it to various factors, some primary reasons being:

*Lack of infrastructure: The lack of infrastructure (port turnaround time, truck speed, labour costs) the country faces adds to the supply side inflation (rise in electricity cost is higher than WPI, labour costs are more linked to CPI than WPI, a reason for labor strikes) that reduces the competitiveness of the export sector and hence a constant depreciation in the currency is required to offset that productivity loss.

For example, INR has depreciated against the Chinese yuan by almost 70% since the start of the century and hence an advantage for exporters, but when we deflate the number by the inflation differential between the two nations {compounded inflation differential of around 67%--4% annual inflation differential) the advantage fades away even after accounting for the recent depreciation. Further, the comparison of the two nations in terms of policies and infrastructure reveals why India's trade deficit as a % of GDP rose from around 2% in 1990s to 10% in 2013, leading to a widening CAD (4.80% of GDP in FY13) and external sector crisis.

*Dollarisation of economy: The external sector i.e. import & export, was at 15% of GDP in 1990s when the economy was rather closed. With the opening up of economy and globalisation, the external sector has expanded to around

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