High inflation calls for more stable rupee

Structurally, India does not enjoy the comfort of a low exchange rate pass-through to the local price level, which has been found to be as high as 60 per cent even in some of the OECD economies. Significant rupee depreciation at the current juncture, therefore, means that India will lose the opportunity to moderate inflationary pressures from an exogenous reduction in international commodity prices.

High inflation and continued weakness in other financial markets (read stocks) is not the right time for significant local currency depreciation, one would think. But that precisely is what has been happening in Indian financial markets in recent months. From its level of 39.40 against the dollar at the turn of the year, the Indian rupee at 45.95 (as of 15 September) is down a full 16 per cent. More interesting is the fact that close to 50 per cent of this fall (a value loss of 7 per cent) has come about in just the past 2 months - as the Indian currency has slid from 42.95 in mid July.

Adjustments in investor risk appetite, the resulting weakness in stock markets and investment capital flows, combined with a rising trade (current a/c) deficit, of course, have driven (and justify to some extent) the weakness in the rupee. But with inflation still hovering ominously in  double digits, one would think that Indian policymakers would go to great lengths to smoothen the fall in the local currency in such an environment.

Importantly and fortunately, India does have the ammunition (large FX reserves) to cushion the rupee's fall. And, to be sure, the ammunition has been expended too - for example, through the sale of FX directly to the oil companies to meet their  requirements of  financing imports. In the attempt to maintain generally stable financial markets. But that has not proved enough if the fairly steep value loss in the Indian currency in recent weeks is any indication.

Given the scale of the crisis in US financial markets - the latest casualties being Lehman Brothers and Merrill Lynch - it is quite possible that aversion for taking on EME risk (such as India) which has been in evidence in the past six months gives way gradually to a higher preference for taking on such risk in the months ahead - purely as a reaction to the fact that India may still represent a ‘relatively’ good investment destination. The rupee could well recover on the back of such an improvement in risk appetite and such a recovery may well aid the process of moderating local prices.  But, in the interim, greater stability in the Indian rupee through more forceful official action (intervention - direct and indirect) may well be called for, crucially, to reinforce the perception that India is still a ‘relatively’ good investment destination.

Exchange rate pass-through to local prices
For even though oil prices have declined, it should not be the case that the gains on the oil price front (and in the prices of many other key Indian imports also such as edible oils and metals) are lost through local currency depreciation. Continued rupee weakness will mean that import prices will stay unchanged with all the attendant implications that have for the local price level as we move further down the chain - from imports to wholesale and then on to retail prices. The import price of a barrel of oil at $ 130 at an exchange rate of Rs.41 to the dollar, for example, is not much different from the price when oil costs $ 100 but the rupee is worth a lot less at Rs.46 to the dollar. 

Greater stability in the rupee's exchange rate in a period of rapid downward adjustment in international commodity prices could significantly enhance the beneficial ‘pass through’ to the local price level from the level of import prices. 

What adds poignancy and urgency to this issue is the fact that the on-going downward correction in international commodity prices appears to be quite exogenous to the developments in the dollar / rupee exchange rate. The potential for generating cost savings on imports and thereby the potential for a softening impact on the local price level is, therefore, much more significant in this environment.

For many commodities and goods which India imports, there is a good chance that suppliers (in the current environment) are not able to eat into the gains (cost savings) of an Indian importer (on account of rupee stability) by inflating the costs of their exports. Such mark-ups have been common in the past and may also continue in a different environment in the future where suppliers perceive that import demand is inelastic to prices and where fixation of prices through bilateral arrangements dominates. As indicated above, the on-going correction in international prices appears to be systemic and driven by the perception of a significant downward adjustment in demand from the advanced countries. 

Is rupee fall designed to moderate demand?
It cannot be the case that permitting a sharp rupee fall in this scenario is designed to moderate oil and overall demand in the economy. This argument does not apply in India, since at the level of retail consumption, prices are not truly reflective of gross import prices (including the exchange rate component) given the various subsidies. The gap between raw material import prices (in rupees) and product selling prices is always sizable in India and thereby supports consumption demand. That gap will possibly widen or at best, remain unchanged, if the rupee depreciates in a scenario of falling raw material prices. 

Indeed, if the objective is to moderate overall import demand, the better route could be through greater rupee stability (and possibly rupee appreciation). While prima facie a stable or strong rupee could make import prices more competitive vis-à-vis local production, the boost this may give imports will be well - moderated by the high(er) interest rates which the process of moving to a stable / strong rupee inevitably means. In other words, higher interest rates (and the resultant drag on consumption / investment activity) can be well expected to moderate the import demand arising purely out of price considerations. 

On the contrary, continued rupee weakness even as global commodity prices soften further may only create the perception that Indian official policy does not exhibit the resolve required to moderate domestic demand.

Is there structural bias towards INR weakness?
It would appear so, since it has been observed that official action to forestall or slow down rupee appreciation is immeasurably stronger - both in terms of the magnitude and frequency of intervention - than is official action to slow down or smoothen rupee depreciation.

From $ 196 billion in April 2007, the FX reserves increased sharply to as much as $ 296 billion in July 2008 even as spot crude oil zoomed from $ 65 to $ 145 in the same period. The relatively flat move in the dollar / rupee exchange rate on the back of this massive dollar supportive intervention vis-à-vis the sharp rise in the dollar's rate from April 2008 is very well depicted in the accompanying chart.

Between July and September, though, as spot crude oil has fallen but has been accompanied by a sharp fall in the rupee also, official action to support the rupee has not been that strong. To be sure, as indicated earlier, the oil companies have been able to access the FX reserves directly through a special scheme, mitigating to some extent the pressure on the rupee. But with a war chest of around $ 290 billion (even after accounting for the dollar sales to the oil companies) and further with around $ 12 billion in outstanding forward purchase positions (as of end July), one would think there was room for undertaking much stronger market intervention operations than has been the case so far.

Exchange rates and local price levels
The bottom line is that India does not enjoy the comfort of low exchange rate pass- through to the import price level at the first stage and then on to the wholesale / retail price level. Artificial repression of petro product prices even as the rupee depreciates may ‘apparently’ indicate that pass through to the local price level from currency depreciation is not high. Actually, shielding local consumption from ‘real’ prices only aggravates overall demand pressures. Further, in respect of other key imports, even such artificial price relief is not possible as local prices fully reflect the gross import prices including the exchange rate component.