How forex buffer can cushion global shock

The fact that the rupee has managed to recover lost ground even as China's stock market crash sent the world's capital markets into bear territory and Asian currencies into a tailspin, reflects the fundamental strength of India's real economy.

While there is a degree of disconnect between stock markets and the real economy, especially in the short run, strong fundamentals eventually tend to kick in. Indian stock markets dominated as they are by FIIs have also turned volatile over fears of a bigger global fallout of the Chinese economic slowdown and the stock market bloodbath. The devaluation of the yuan has also triggered fears that Chinese exports may turn cheaper and displace competing nations in the global market. However, India seems to be better prepared than any time in the past to deal with foreign shocks and this is in large measure due to the crash in international oil prices.

Crude Oil

India imports 80 per cent of its crude requirement which accounts for close to one-third of the total import bill. A sharp fall in oil prices, therefore, leads to a commensurate reduction in the outgo of foreign exchange which in turn strengthens the rupee vis--vis the US dollar.

The last time the rupee had turned volatile was in the June-September period during 2013 as fears of the US Federal Reserve switching to a tight money policy had triggered an exodus of foreign capital from the stock markets. The rupee then went through its worst crisis in more than two decades with the exchange rate against the US dollar falling as low as 69.

The current account deficit, which indicates the amount by which a country's foreign exchange earnings fall short of its import bill, had touched an unprecedented 6.7 per cent of GDP at the time. This had left the country dependent on foreign portfolio investments in the stock markets to finance imports which left it very vulnerable to external shocks as this is hot money that can suddenly leave a nation's shores.

With the current account deficit coming down to less than 1 per cent of GDP, India is definitely on a more solid footing. Crude prices in 2013-14 had crossed peak levels of $100 a barrel and the oil import bill for the year worked out to a whopping $ 143 billion. During 2014-15 crude prices eased to some extent bringing the oil import bill down to $ 112.7 billion.

The current financial year has seen the declining price trend continue with the Indian basket of crude oil coming down to $45 per barrel in recent days. India's crude import bill for the first five months (April-July) of the current financial year works out to $ 27.6 billion compared with the corresponding figure of $ 47.3 billion during the same period of 2013-14.

Apart from crude, the price of coal which is also imported in large quantities has also come down sharply resulting in a huge saving of foreign exchange and the current account deficit remaining in check at a time when exports have slowed.

The country's foreign exchange reserves at $ 355 billion provide a comfortable cushion to finance imports. It can also be used by the RBI to prop up the rupee when it turns volatile in the short run due to external shocks such as the latest Chinese stock market meltdown.

RBI Governor Raghuram Rajan has already indicated that he is ready to use the country's foreign exchange reserves to curb volatility in the rupee as the Indian currency fell to its lowest level on Monday since late 2013.

Weak Rupee

If the value of the rupee falls, the RBI can sell dollars in the market in order to increase the availability of greenbacks which strengthens the Indian currency. A weak rupee results in imports of essential commodities such as crude oil, for which payments are made in dollars, becoming costlier. Similarly, Indians travelling abroad or studying in foreign universities will have to shell out more.

Indian corporates that have borrowed from foreign banks also have to pay more for servicing their debt when the rupee depreciates which results in eroding their profits. Besides, a volatile rupee hits exports as the value of the merchandise tends to fluctuate which adds an element of uncertainty to the business.

External Challenges

The country's macroeconomic fundamentals have also been fortified with the government bringing down the rate of inflation and reducing the fiscal deficit to manageable limits.

However, while India is better prepared to deal with external shocks it does not mean that it is completely out of the woods. The country's goods exports have fallen for eight straight months till July as global demand remained sluggish, posing a major challenge for the government to boost economic growth.

The government has been going all out to attract foreign direct investment to create more jobs and bring in high technology into the country but legacy issues such as weak infrastructure are proving to be a drag. Agricultural growth has slowed and although the monsoon has not turned out to be as bad as was expected, the rains in July were less than normal.

Corporate investments have also failed to pick up in recent months as the government has run into a political hurdle with its economic reforms process.

The writer is Chief,Economic Bureau, Mail Today