Long-term steps needed to strengthen the rupee as current-account gap weighs

The rupee plunged to a fresh record low against the US dollar on Monday. The local currency closed at 58.16 to the dollar compared with 57.06 on Friday. And with little support from export earnings and foreign inflows, the local currency is widely expected to cross the 60-mark against the greenback soon.

Sonal Varma, Chief Economist at Nomura India, says the fear of the US reducing its quantitative easing programme is impacting currencies of all emerging economies. With a huge current account deficit, India is more vulnerable to currency shocks. She expects the Reserve Bank of India (RBI) to intervene only to stem the high volatility in the foreign-exchange market.

"We should not expect any aggressive dollar selling by the RBI," she says.

A dealer at a state-run bank says the rupee's sharp depreciation in the past couple of weeks could prevent RBI from cutting interest rates. "A good differential of interest rates between India and say the US will attract remittances into India," he adds.

There are several structural reasons for the rupee's weakness.

The genesis of the problem lies in the widening trade and current account deficits. The trade deficit for April was $17.7 billion compared with $14.04 billion a year earlier. The government is trying to narrow the gap between imports and exports but it can do little as measures to boost export competitiveness cannot be implemented overnight. That requires a sustained focus on manufacturing high-end and sophisticated products.

While India's software services sector has been a success story, the country hasn't been able to establish its mark in manufacturing. Many Indian companies are happy supplying seat belts to global auto makers or floor beams to aircraft manufacturers. The export story will have to replicate China's success as a factory for global markets. That requires good political governance, a proactive bureaucracy, land and labor reforms, and world-class infrastructure.

The government is fighting the trade deficit battle largely by restricting imports. This is an easier and potent tool in the short run. But it is highly unpopular. Of the two big import items - oil and gold - the government has quadrupled the import duty on the yellow metal to 8 per cent in just a year. This could be further increased depending upon the magnitude of the rupee's depreciation in coming months.

India is also running a historically high current account deficit (CAD) of more than 5 per cent of gross domestic product. The current account gap is the broadest measure of trade and investment flows. It includes trade in goods and services as well as remittances. In the fourth quarter of 2012, CAD was $32.63 billion.

There are countries with a trade deficit, but a current account surplus. This happens when the trade gap is financed through services and other capital inflows.

But India doesn't have the luxury of dollar inflows into its economy or the capital markets. The kind of inflows India attracted between 2003 and 2008 no longer exist today.

The corporate sector's performance is also to be blamed as many companies made billion-dollar acquisitions by leveraging their balance sheets. The growing cases of bad loans and debt restructuring are eroding the valuation of these companies in the stock market, discouraging foreign investors to pump money here.

The policy paralysis, corruption scandals, and problems related to land acquisition and mining have halted the flow of foreign direct investment into the country.

The short-term solutions to halt the rupee's slide may bring temporary relief. Also, the country cannot rely on foreign institutional investment as these capital flows are volatile.

The long-term solution lies in attracting more permanent capital in the form of foreign direct investment and in becoming export competitive globally.