Falling rupee a symptom: Weakening economy is the disease

The chart above is a graphic story of the Indian Rupee vs. the United States Dollar over the last five years. It, therefore, shouldn’t surprise anyone that the INR fell to an all-time low of Rs 77.4 to a U.S. Dollar earlier this month.

What has happened was inevitable. The reality is that India’s economy is weak, and it is getting reflected in the value of the currency.

The immediate reason was a hike in the U.S. interest rates by the Federal Reserve which made U.S. Treasury bonds more attractive to foreign investors, leading to an exit of funds from India to a relative safe haven of the United States. Foreign investors had already pulled out a massive Rs 1.22 lakh crore from the Indian equity and debt markets in the year 2021-22. In the current fiscal 2022-23, global investors have already made a net sale of equity and debt of Rs 25,594 crore in the month of April alone.

The second factor was an increase in the repo rates of India’s central bank, the Reserve Bank of India (RBI) by 40 basis points. The objective of RBI was to bring down runaway inflation. Nevertheless, the interest rate increase dampened business sentiments which in turn weakened the INR.

The repo rate is the rate at which the RBI lends money to commercial banks in the country if they face a lack of funds. The central bank gives short-term loans to commercial banks against government bonds or treasury bills. The repo rate is basically used by the central bank to have a handle on inflation by regulating liquidity.

High fuel prices caused inflation

Inflation was already running high, as daily increases in fuel prices were having a cascading effect on prices of everyday items. It had affected middle-class spending, as without much of a disposable income, they were forced to spend only on essentials. The poor were in an even worse shape, and were cutting back on food. Millions had been pushed into poverty during the pandemic lockdowns, inflation now hit them when there were at their most vulnerable.

Policy mistakes weakened the economy

But these are only a fraction of the reasons why the rupee had been on a slope for the last five years or more. The basic cause is– the Indian economy is simply not doing well ever since the government in its inexplicable wisdom pulled the handbrakes with a draconian decision to demonetize the currency in November 2016. In one stroke, almost 80% of the liquidity of the economy was sucked out. Millions of jobs were lost, as companies went out of business. Commerce and industry were thrown into utter chaos.

The micro-small-medium-enterprises, which is almost one-third of the economy were the worst affected as thousands of units downed shutters never to reopen again. The GDP (Gross Domestic Product) tanked by nearly 2%.

This was followed by a tardy implementation of the Goods & Services Tax (GST) that further created hassles for the small and medium enterprises, increased cost of compliance and made doing business highly cumbersome.

The double whammy of demonetization and GST had dealt a body blow to the Indian economy, weakening its ability to withstand shocks. And more severe shocks did come as Covid19 hit the world in 2020. In March that year India announced an abrupt lockdown.

Not only did it cause catastrophic human sufferings, but it simply brought the economy to a standstill. Joblessness increased further wearying an already wobbly economy. Around 230 million Indians had been pushed into poverty during the pandemic lockdowns, per a report by a private think-tank Azim Premji University.

The shock of Ukraine-Russia war

If these weren’t enough, the economy made vulnerable by policy missteps of the government, could not withstand a further shock of high oil prices triggered by Russia’s attack on Ukraine.

India imports 80% of its oil requirement and any increase in its prices is bound to affect its economy, resulting in a trade deficit, despite rising exports. India's trade deficit rose 87.5% to US$192.41 billion in 2021-22 as against US$102.63 billion in the previous year.

A yawning trade deficit

India historically runs a trade deficit. According to Acuité Ratings the cumulative trade deficit for 2021-22 has widened to more than a decade high at $192 billion. It was in 2012-13 when the trade deficit peaked at $190 billion.

Given the higher crude prices, Acuité Ratings expects the trade deficit to widen further. A higher trade deficit will put pressure on the current account deficit (CAD), which in turn will increase demand for foreign currency, especially dollars, to finance the deficit, and affect the INR value vs. the U.S.Dollar.

High debt-to-GDP

One of the most worrying signals of the economy is the debt-to-GDP ratio. India’s total general government debt (Centre plus states) to GDP ratio increased from 48.8% in the 1980s to 89.6% in FY21. Public debt (Central government liabilities) rose from Rs128 lakh crore in FY21 to a high of Rs135.87 lakh crore by March 2022.

This means that there is a nearly 90% debt burden on the total value of goods and services the country produces. Servicing this debt will be a huge strain on the economy.

Meanwhile, The International Monetary Fund has further slashed India's economic growth prospects for 2022 to 8.2% from its earlier projection of 9%, which in itself was lowered from 9.5%. Research firm CRISIL has reiterated its December 2021 forecast of India’s GDP growth at 7.8% for fiscal year 2022-2023. The ongoing geopolitical turmoil in Europe between Russia & Ukraine has offset any potential upside due to the early end of a mild third wave of Covid-19 infections, it said.

Weak currency is a symptom

Against this backdrop it wasn’t at all surprising that the rupee fell to its lowest against the U.S. Dollar. The value of a currency is just a symptom of a deeper malaise that ails the economy. If the economy is feeble, it’s a no-brainer that its currency will also be weak.

Raising interest rates, without addressing core issues like rising fuel prices will not be enough to combat inflation. It’s like shifting gears in a car, without pressing the clutch.