India: XR volatility and Trade

The Indian rupee is classified as a managed float although it was to be a market determined rate since 1993. A conscious intervention in the currency market had gradually built up huge reserves and allowed the central bank to manage the exchange rate in a historically observed band 43-46. The transactions on exports, imports and invisibles were comfortable in the de facto exchange rate band. There were very little incentives to hedge the earnings as the band was rarely breached due to active interventions by the central bank. The story had to change in the face of huge capital inflows.

The Reserve Bank had made all the attempts to manage the peg with enormous sterilisation costs and building up of foreign exchange reserves to all time high ( USD 312 Billion). Consequently, the rupee had to appreciate upto the level of 38/39 while everything else was booming. Till December 2007 the appreciation continued. The exporters concerns were overlooked as it was still performing well and the net earnings on invisibles were offsetting the huge import bills arising from fast rise in crude prices. The story took another sharp turn in the beginning of 2008 and clearly after September, 2008. There was steady outflow of capital from the country because of downturns in equity markets as the sub-prime crisis was unfolding. A ‘sudden’ outflow of about USD 30 billion in Oct-Dec/2008 had forced the rupee to depreciate to 50. Interestingly, RBI had taken a complete different stance to float the currency and preferred to use it as an automatic stabilizer. Most of the businesses were anticipating a strong RBI intervention as was practiced earlier and had a bet on rupee will not breach its de facto pegged band. Such positions in currency futures have generated a huge loss for them. As the demand from the rest of the world was drying up fast, the depreciation of rupee could hardly help the exporters. This was an additional pain on the back of currency futures losses.

The implications are still being felt in the real sector. Quick gyrations in exchange rate, exports downturns had its costs in terms of layoffs. On imports front, the country had a relief, despite a 25 per cent swift depreciation, due to sharp fall in crude oil import bills. The invisibles have always helped the current account to stay afloat despite deficits in the trade balance. A slow pace of growth in travels, business services and investment income receipts had it dent on invisibles receipts, slowing it down to 19 per cent in April-December, 2008. A corresponding 9 per cent outflow on invisibles was triggered by slowdown in travels and number of business services has provided a cushion to finance 65 per cent of the trade deficit. With a lag of adjustment, the imports and exports, both shrunk co-synchronously, and leading to a smaller deficit trade balance. Going forward, the spill-over in real sector in terms of fall in output and job losses have been terrific. The unfolding global crisis and uncertainty, with more and more inflows of bad news, had dampened the confidence. With Drop in global prices of tradeables has reduced profitability of domestic producers of these goods and worsened the viability of their investment projects. As a result the projects are shelved. On the positive side, India will benefit from the drop in commodity prices, as it was a net importer of USD 92 billion in 2007-08. A recent recovery in the equity market and up move in gold prices will at least partially offset the wealth melt downs in real estate and equities.