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The Indian rupee is in free fall against the U.S. dollar and many people predict that it will fall still further to touch 70 rupees to the dollar. The rupee has already depreciated more than 13% this year and a recent intervention by the central bank, the Reserve Bank of India (RBI), has done little to arrest the slide. Other steps such as restrictions on overseas investment by Indian companies and overseas remittances by Indians have been ineffectual. It is important to understand the reasons for the rupee depreciation in order to understand what the Indian government should do about it. As always, there are a number of factors that come into play.

The high (and worsening) current account deficit is one of the major reasons for the fall in the value of the rupee. For the year ending March, 2013, the deficit touched the record level of 4.8% of GDP. Export growth has been unsatisfactory because exporters have been unable to find new markets and products and there is still plenty of bureaucratic red tape in the way of exporters. Even traditional exports have not shown the kind of resilience that one would expect. Despite all the lip service paid to reform, India has failed to attract the kind of Foreign Direct Investment (FDI) that it has the potential to achieve. In fact, giant companies like ArcelorMittal (NYSE:MT) and Posco (NYSE:PKX) have canceled multibillion dollar projects because of protracted delays and problems with areas such as land acquisition. In fact, in the previous year, Indian companies invested more overseas than overseas companies did in India.

Overseas investors have pulled out almost $3 billion from the Indian capital markets in July on top of the record outflow of more than $7.5 billion in June. This has put pressure on the rupee which is likely to get worse because the major investment bank Goldman Sachs has downgraded Indian equities to underweight and recommended that foreign investors be selective. The rising import bill, primarily on account of gold, is another major cause for concern.

Above all, it must be recognized that the rupee depreciation is not by itself a problem to be solved but a symptom of the lack of confidence in the India story. Economic growth continues to be constrained and the Reserve Bank has revised its growth forecast downwards from 5.7% to 5.5%. It is clear that the currency market which is driven mainly by sentiment believes that India is not reforming its economic and monetary policy quickly enough create a favorable impression. Unfortunately, there are no short term fixes and the measures taken so far such as the reduction in gold imports or the liberalization of the rules for non-resident Indian deposits can at best be viewed as Band-Aid solutions. Other short term steps could be to try and delay payments for imports and induce exporters to bring back the dollars that they have stashed overseas into the country.

The latest moves have partially reduced the effect of earlier monetary policy tightening and caused many observers to charge the government with flip flops in policy even though India is one of several emerging countries that is suffering from the flight of capital back into the United States where the tapering off of bond purchases by the Fed is making dollar assets more attractive to investors. The Reserve Bank says that it must balance the need for macroeconomic stability with the continued flow of credit to the productive parts of the economy. Foreign investors look for credibility and predictability in central bank policies and do not see either in the Reserve Bank. Instead of providing reassurance, the measures taken so far appear to be knee jerk reactions rather than a part of a cohesive long-term strategy for economic growth and recovery. One analyst says that the objectives of promoting growth and defending the currency are contradictory and it is unclear whether the RBI policy is trying to protect growth or defend the rupee. Market intervention is ruled out because it will merely put money into the pockets of speculators as the Bank of England did some years ago when it put a billion dollars into the pockets of speculator George Soros when it tried to defend the pound sterling.

In the end, the Indian government has to restore investor confidence in the Indian economy and this is by no means an easy thing to do. Slowing economic growth and the pressures of inflation make it hard to develop an appropriate monetary policy. Vested domestic interests will try and block measures to boost foreign investment and the associated hard currency inflows that could strengthen the rupee. There is no doubt that a coherent and credible long term policy on reform and liberalization needs to be established and difficult decisions have to be taken. It no longer makes some sense to pretend that the exchange rate is the problem of the finance ministry and the Reserve Bank. Rupee depreciation is now a major national crisis and must be tackled on a war footing.

Source: How Should India Combat Rupee Depreciation?