While announcing the cut in repo rates by 0.25 per cent and cut in cash reserve rates by 0.25 per cent, the Reserve Bank of India (RBI) governor flagged the widening current account deficit (CAD) as a major risk, especially in the context of slowing growth and high fiscal deficit. He said "financing the CAD with increasingly risky and volatile flows increases the economy's vulnerability to sudden shifts in risk appetite and liquidity preference, potentially threatening macroeconomic and exchange rate stability".
Addressing a press conference, the governor expressed concern about the quality of CAD. "If we had high CAD because we were importing capital goods, that would be okay. If CAD is high because we are importing a lot of diesel when demand is not price-elastic and if we are importing a lot of gold, that is a concern," he said.
The anxiety of the RBI governor drew a number of questions on managing the CAD in the press conference as well as his teleconference with researchers and analysts. Strangely, in all his responses to questions, one could get to hear very little about reviving exports. He affirmed that the RBI policy on exchange rates continues to be one of intervening to curb excessive volatility and no more. That policy is a source of worry for many renowned analysts.
S S Tarapore, former deputy governor of RBI, says the exchange rate policy is increasingly being questioned. With the inflation rate persistently above that in the major industrial countries, the rupee is clearly overvalued. Adjusting for inflation rate differentials, the present nominal dollar-rupee rate of around $1=Rs 54 should be closer to $1=Rs 70. But our macho spirits want an appreciation of the rupee, which goes against fundamentals," he says. He warns the external debt is now higher than the forex reserves, and short-term debt, on a residual maturity basis in June 2012, was as high as 43 per cent of total external debt.
"A CAD which can be easily financed in one period can become difficult to manage in another. The exodus of capital can be very sudden and large when the international community loses confidence in India," Tarapore cautions. A V Rajwade, an eminent expert in foreign exchange matters, has long argued that our overvalued exchange rate not only affects the current account directly, but also the savings: Investment imbalance by reducing savings besides impacting export competitiveness and employment levels adversely. He has also estimated that taking 2001-02 as the base, the wholesale price index in India and the consumer price index in the US as measures of inflation, the nominal rate needed to be somewhere close to Rs 70 per dollar by the end of March 2012, for the real rate to be where it was 10 years ago.
So, many dissonant voices question the neglect of exchange rate management as an important policy tool to restore export competitiveness and recommend sterilisation of foreign exchange inflows to infuse liquidity, thereby boosting forex reserves and also ensuring export competitiveness. The only explanation is the fear that depreciation of rupee in real terms may lead to higher fiscal deficit and inflation rate. Anyway, with RBI leaving the job of reining in the CAD to the government, the only hope is possible abolition of unnecessary customs duty exemptions.