The connection between disrupted Parliament and the fallen rupee is more apparent than meets the eye. Hamstrung by the rising clamour over its perceived ‘policy paralysis’, the government hurriedly put forth the proposal on the foreign direct investment (FDI) in retail just as Parliament’s winter session took off. The timing couldn’t have been worse.
A steep depreciation in the rupee, which followed net capital outflows in the last few weeks, coincided with the opening of the winter session. While this is due to foreign investors seeking dollars in the wake of the European Union’s economic debacle and the falling values of all currencies, domestic issues do account for the fall in the value of the rupee by 14% — the steepest in Asia. While this has improved somewhat now, uncertainty remains.
An inflation rate of close to 9% has lowered the rupee’s purchasing power. Poor infrastructure, half-baked reforms and corruption have also prevented long-term investment capital from holding ground in the country. These factors have an important bearing on currency values. The outflow of capital and the devaluation of the rupee are mutually reinforcing and will prove to be a difficult issue for India to tackle among all the emerging markets. India’s growth feeds on domestic demand and not export earnings. For this, the financial system needs to borrow foreign capital.
Deficits are likely to widen due to the compulsion of importing oil and other essential goods at increasing costs. At the same time, exports have fallen further due to the deepening EU crisis, the EU being India’s largest trading partner.
India’s ratings today stand at investment grade, just one level above junk and are likely to move lower. In that event, investment funds will either forcibly close their positions or ask for a higher return: something already happening in anticipation of a slowing economy.
Being held in foreign currency, a significant part of the foreign exchange reserve has also eroded in value. About a year ago, India had a discernible edge among the emerging markets when the rupee’s promise of highest yields led to a scramble among investors. At that time, the current account deficit led by a trade deficit was widening rapidly. An attempt was made to balance this by a capital account surplus coming from short-term inflows and a massive portfolio equity flow.
These flows were largely from foreign institutional investors (FIIs) who could pull out anytime. The FIIs stood in distinction from the FDIs, which are long-term investments with longer lock-in periods. India’s currency value and effective exchange rate were then shaping out of capital movements instead of real economic activity.
In such a situation, a rise in short-term loans along with a current account deficit was clearly a bad idea. The government turned a blind eye to the fact that the investors were not interested in the long-term bonds of a country with a high inflation risk. In the face of such speculative flows dominating the capital account, a resort to current account and exchange rate management was necessary. Instead, the government invited more such capital and kept its hands off exchange rate interventions.
This, coupled with inflation, low industrial production and manufacturing, has paved the way for an impending macro-economic crisis. This, in turn, will determine the unspoken but the shaping context for the success or failure for FDI in retail — or any other policy for that matter. The present failure of parliamentary proceedings, then, only mirrors the political economy of the country in the making.