24 July 2018

What the Falling Rupee Means for India's Economy

A strengthening U.S. dollar is causing the rupee to depreciate as the cost of India's hefty, dollar-denominated oil imports are rising. The falling rupee suggests that Indian monetary policy will enter a tightening phase to stem debt outflows, manage inflation and ease the currency's fall in the world's fastest-growing economy. With an eye on re-election in 2019, Prime Minister Narendra Modi will continue to indulge in populist spending, which will expand the country's deficit and slow the government's fiscal consolidation drive. While economic trends in India will weaken Modi as a candidate, the absence of a unified opposition indicates that he will remain the favorite in the 2019 general elections. 

With a gross domestic product of $2.6 trillion, India recently eclipsed France to become the world's sixth-largest economy. What's more, the South Asian country of nearly 1.3 billion people is home to the world's fastest-growing economy, having edged out China with its 7.7 percent growth rate from January through March. While these figures are impressive, they rest uncomfortably alongside less sanguine facets of India's macroeconomic picture.

The Big Picture

Indian Prime Minister Narendra Modi will seek another five-year term in 2019 to try to advance the land, labor and tax reforms that he argues are necessary to produce the job growth needed to absorb the 12 million Indians who enter the labor market each year. But a weakening rupee, rising oil prices and other external vulnerabilities point to the challenges ahead for Modi as he campaigns for re-election.

Ongoing shifts in U.S. monetary policy are causing India's rupee to depreciate against the dollar. As the U.S. Federal Reserve cautiously raises interest rates to keep inflation in check — in June, the U.S. consumer price index hit its highest level since 2012 — the U.S. Treasury has increased its issuance of bonds to cover large deficits resulting from recent U.S. tax cuts. Together, these U.S. decisions have put additional pressure on the rupee, which has tumbled more than 8 percent against the rising dollar in 2018. This decline makes the rupee Asia's worst-performing currency this year (though India's real effective exchange rate — a measure of the rupee's value in relation to trading partner currencies — is down only 3.5 percent since December).

India's $409 billion in foreign exchange reserves enable it to weather any currency shocks, giving the Reserve Bank of India the ability to intervene by quietly selling dollars to pull rupees out of circulation and thereby boost their value. But broadly speaking, the rupee's performance against the dollar in tandem with rising oil prices will increase India's import bill, lead to debt outflows and compel the Reserve Bank to embark on its own phase of monetary tightening while Prime Minister Narendra Modi's populist spending in support of his 2019 re-election bid is expanding the country's fiscal deficit.

When voters swept Modi's Bharatiya Janata Party to power in May 2014, giving the party the first majority in the lower house of Parliament in 30 years, the price of India's crude oil basket over the previous three years had averaged $108 per barrel. Oil prices crashed soon after Modi took power, resulting in the per-barrel average falling to $58 over the next three years. This fall in oil prices proved a blessing for Modi. It enabled his administration to build on its political momentum by projecting itself as a sage steward of the Indian economy through trimming the current account deficit and keeping inflation in check while pocketing more revenue by raising taxes on fuel (meaning consumers didn't see more than a 5 percent fall in fuel prices).

However, rising oil prices combined with increasing demand and a weakening rupee now threaten to scale back this advantage. In fiscal 2017-18, for example, which ended March 31, India's oil import bill jumped by $20 billion. India's current account deficit in the fourth quarter of fiscal 2017-18 ballooned to $13 billion. By comparison, its current account deficit during all of fiscal 2016-17 was $14.4 billion. India is the world's third-largest consumer of oil and imports nearly 80 percent of its crude. And since oil is a key input across various sectors of the economy, rising crude prices will put upward pressure on inflation. Indeed, the latest inflation figures of 5 percent in June point to a five-month high.

Investors already have pulled $6.6 billion from India's capital markets, and that figure includes the first foreign portfolio investment outflows in more than a decade as measured during the first six months of the year. Investors, especially in bond markets, are reallocating their capital to the United States, where the yields on Treasury bonds — considered the world's safest investment — are rising in tandem with U.S. interest rates. But the Reserve Bank of India is not sitting idly by. For the first time under Modi's administration, the Indian central bank raised its interest rate by a quarter-percentage point to 6.25 percent in June. While the move can blunt the outflow of funds — emerging market securities typically deliver higher yields because of higher risk — it's coming at an inopportune time for the prime minister as he seeks to indulge in populist spending to court farmers in support of his 2019 re-election campaign.

India's fiscal consolidation drive will slow as a consequence. Initially, the government had set a deficit target of 3.2 percent of GDP in fiscal 2017-18 and 3 percent in fiscal 2018-19. But last year, the deficit ended up being 3.5 percent of GDP, and the Finance Ministry set a target of 3.3 percent for this year. So the rising interest rates are going to raise the government's borrowing costs as it essentially spends money on credit. For Modi, however, politics will override economics: While India's farmers are stratified along economic, political and social lines, the group collectively makes up the country's most important constituency. The country is home to some of the world's largest cities — more people live in the Delhi metropolitan area than live in Greece — but about 70 percent of Indians still live in the countryside. This is why agriculture accounts for about half of the labor force, even as it contributes to a dwindling share of the economy. (Already, Modi has promised to boost the minimum support prices the government has promised to pay farmers, adding another $2.18 billion to the government's expenditure.)

Given India's immense diversity in language, religion, ethnicity and caste, encouraging unity is a key pillar of Modi's grand strategy. His 2014 parliamentary majority positioned his government to advance the economic component of promoting unity through legislating the Goods and Services Tax. The tax aims to undo the economic fragmentation along state lines by creating a single national value-added tax (though there are complications on this front, to be sure). The tax itself is part of a trinity of economic reforms — including land and labor overhauls — that the country needs to pass to create the labor-intensive economic growth capable of absorbing the 12 million Indians who enter the job market annually. Otherwise, it will fail to capitalize on its demographic dividend, and in the extreme scenario, large swaths of unemployed and underemployed people can lead to widespread social unrest.

Thus, for all the expectations triggered by its impressive growth rate, a weakening rupee, an overreliance on oil imports and a mediocre export performance are some of the economy's key external vulnerabilities. And although India's macroeconomic fundamentals are strong enough to avert a crisis in the near term, the combination of a monetary tightening cycle and increased populist spending will strain the fiscal deficit. But this is a price Modi is willing to pay as he courts voters. The economy clearly will be his weakest card come 2019. But the prime minister's formidable campaigning skills and an opposition still struggling to coalesce mean the advantage belongs to Modi.

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