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With our bucks to the wall

The Indian economy needs more piecemeal efforts to arrest the rupee's freefall.

india Updated: Dec 14, 2011 23:23 IST

The widest impact of a freefalling rupee is in the higher prices of oil we buy in the international market. Energy is India's biggest imp-ort, and 20% fall in the dollar exchange rate makes crude oil that much costlier. The country's largest refiner, Indian Oil Corporation, alone imports crude oil in the region of $5 billion a month. The government has allowed oil companies a facility to source their dollar requirements from the Reserve Bank of India (RBI). This is band-aid, it doesn't cover the hit the oil marketing companies are taking on account of the rupee's fall. The squeeze is magnified by prices of petroleum products administered to sell at below cost. Although the government absorbs some of the losses for selling diesel and cooking fuels at subsidised rates, the pressure for passing on the higher cost of crude oil to consumers is exerted through the worsening fiscal deficit.

Capital goods form another big chunk of our overall import basket, which suffers from adverse movements in the exchange rate. Latest data shows India's industrial output contracted by 5% in October 2011 from a year ago. Over April-October, industrial growth has slowed to a crawl; it's down to 3.5% from a healthy 8.7% in the same period of 2010. Production of domestic capital goods shrank 25.5% in October 2011, a precipitous fall from 21.1% growth in the same month a year earlier. Companies are simply not putting up fresh capacity in a season of galloping interest rates and raw material prices. Against this backdrop, wilting demand for imports of plant and machinery to set up fresh industrial capacity is an extra worry. The response to capital flight is monetary tightening, but that option is already nearing exhaustion after a bruising battle with inflation at home. If the RBI now starts selling dollars, it will have to suck more rupees out of the system, pushing up interest rates further.

The rupee has seen an equally dramatic fall in 2008, when international investors fled to the safety of dollar debt. The ensuing recovery was also fairly breathtaking as emerging markets regained their lustre. This time, however, the rupee may find it more difficult to climb back from its current levels once the euro zone crisis rolls over. The trade deficit is now three times as big as it was in 2008. And India's foreign exchange reserves today can fund eight months of imports, down from a year in 2008. The new equilibrium for the rupee is likely to be lower, incorporating the current trade balance. On the capital account, the government can revive global investor sentiment by displaying a renewed commitment to reforms. Since interest rates cannot be raised or capital flows curbed, more piecemeal efforts to arrest the rupee's fall are needed to ease the inflationary pressure on the economy.