In Retrospect

Ephemeral to sustainable

Before the global trend of crisis takes stagflation prone India into its grip, the RBI should shift its focus from enhancing short-term inflow of foreign currency to stemming large and sustained capital outflows from India

Ephemeral to sustainable

Three concurrent problems — runway inflation, massive unemployment, and steady depreciation of the rupee against the US dollar — are crushing the Indian economy at present. In June 2022, the annual inflation rate was 7.01 per cent. Prices of food rose to 7.56 per cent, particularly that of vegetables (17.37 per cent), spices (11.04 per cent), and oil and fats (9.36 per cent). Additional upward pressure came from costs of transportation & communication (6.9 per cent), health (5.47 per cent), education (4.51 per cent), and housing (3.93 per cent).

CMIE data shows that the unemployment rate rose from 7.1 per cent in May to 7.8 per cent in June, with rural unemployment rising by 1.4 percentage points to 8 per cent while the unemployment rate in urban India declined by 0.9 percentage points to 7.3 per cent. The employment rate in India fell to 35.8 per cent in June 2022, which is its lowest level in two years. Implicitly, less than 36 per cent of the working-age population in India was employed in June 2022, reported Economic Times.

Meanwhile, the Indian rupee has hit its all-time low and breached the psychological mark of Rs 80 per dollar. The dollar saw the strongest first half in over a decade, buoyed by recession fears and European woes. Reacting to this, the Finance Ministry said in the Lok Sabha, "Global factors such as the Russia-Ukraine conflict, soaring crude oil prices, and tightening of global financial conditions are the major reasons for the weakening of the Indian rupee against the US dollar."

The depreciating rupee is also likely to have a direct impact on spending as oil, imports, loans, etc. will get pricey. Increasing prices might also accelerate inflation. As the rupee falls, foreign investors will look to pull out of Indian equities, leading to a sharp fall in equity markets. This will result in a decline in stock and mutual funds' investments, reported Business Today.

The country's trade deficit also hit an all-time high in June at USD 25.6 billion, up from USD 24.3 billion in May. The record deficit followed a rise in crude oil and coal imports. As per a report by Times of India, Nomura expects the Indian rupee to reach Rs 82 against the US dollar by the third quarter of 2022 and Rs 81 by the fourth quarter.

In India, the cumulative impact of the deteriorating global environment has been felt on both the current account (widening trade deficit) and capital account (large portfolio outflows), thereby amplifying the depreciation bias of the rupee against the US dollar. Foreign portfolio investors have pulled out a whopping Rs 2,71,950 crore (USD 35.6 billion) from the Indian equity and debt markets over the period between October 2021 to June 2022.

The crisis

It is argued that the recent upsurge in inflation, due to the black swan event, i.e., the war in Europe, on top of the Covid-19 pandemic, offers a classic example of the globalized nature of current inflation. Around 77 per cent of countries reported an acceleration in inflation in 2021, and this proportion is expected to rise further to 90 per cent in 2022, according to the IMF's latest projection. Moreover, among advanced economies (against an inflation target of 2 per cent) and emerging market economies (against an average target of about 3-5 per cent), two-thirds are witnessing inflation above 7 per cent. These factors have an even more conspicuous effect on net commodity importing countries like India.

Reacting to these developments, Shaktikanta Das, Governor, Reserve Bank of India, said on July 9, 2022, "The insurance against such inevitable global shocks ultimately is built on sound economic fundamentals, strong institutions, and smart policies. Price stability is key to maintaining macroeconomic and financial stability. In a broader sense, inflation is a measure of the trust and confidence that the public repose in the economic institutions of a country. While factors beyond our control may affect inflation in the short run, its trajectory over the medium term is determined by monetary policy. Therefore, monetary policy must take timely actions to anchor inflation and inflation expectations so as to place the economy on a strong and sustainable growth pedestal."

RBI Initiatives

During the last few weeks, RBI has taken few initiatives to arrest further depreciation of the Indian currency.

First, the Reserve Bank of India has recommended that the government approach the BRICS Bank (now known as the New Development Bank) to sell rupee-denominated bonds in overseas markets, reported Millennium Post. Selling rupee bonds, a senior official aware of the central bank's recommendation said, will help India tap foreign savings amid the government's record borrowing program and rising yields in the domestic markets. Though no such announcement has been made by the government as yet, experts have doubts about the success of such rupee bonds at a time when the rupee is depreciating against the USD.

Second, the Reserve Bank of India (RBI) announced on July 6 a number of measures to attract greater foreign exchange flows to India. "In order to further diversify and expand the sources of forex funding so as to mitigate volatility and dampen global spill-overs, it has been decided to undertake measures to enhance forex inflows while ensuring overall macroeconomic and financial stability", the RBI said in its press release.

The measures, as announced by the RBI, are regulatory relaxations aimed at attracting larger forex flows through bank deposits, foreign portfolio investments in debt instruments, and external commercial borrowings (ECBs) by Indian corporates.

Commenting on this, Kavaljit Singh (July 26, 2022) wrote: "The efficacy of these new measures will be minimal as they are introduced for a brief and temporary period. Most would lapse from the end of October until the end of December. Even if they are extended for an additional six months or made permanent, it is highly unlikely that they will open the floodgates of foreign exchange flows to India to offset large outflows that push the rupee down."

Citing the case of relaxing limits on foreign portfolio investments in domestic debt instruments, he said, first, foreign portfolio investors' appetite for Indian government bonds is low, as they have only utilized 29 per cent of the entire permissible limits. Second, why should FPIs invest in short-term funds in India when they can get better returns by investing in US treasury bills for the same time period? This is especially true when one considers the higher hedging costs that come with investing in rupee-denominated debt instruments in the current environment. Third, the differential between US and Indian policy rates is narrowing which dissuades risk-averse portfolio investors from entering Indian debt markets, given the general climate of uncertainty. Unless interest rates rise significantly in India, the new relaxations will not help attract additional dollar inflows into domestic debt instruments.

The measures announced by the RBI are primarily aimed at liberalizing capital inflows, while the immediate and most important challenge is to stem large and sustained capital outflows from India. In the short term, policy measures should be geared toward managing capital outflows, which are more challenging to manage than capital inflows. But so far, the RBI has refrained from introducing new capital controls that may prove to be a useful component of the policy toolkit to handle capital outflows. An exit tax with clearly defined schedules and rules could be worth considering. The RBI could also deploy some quantity-based controls to slow the pace of capital outflows from domestic financial markets.

Third, On July 11, 2022, RBI issued a circular pertaining to International Trade Settlement in Indian Rupees (INR). The circular states, "In order to promote the growth of global trade with emphasis on exports from India and to support the increasing interest of the global trading community

in INR, it has been decided to

put in place an additional arrangement for invoicing, payment, and settlement of exports/imports in INR. Before putting in place this mechanism, AD banks shall require prior approval from the Foreign Exchange Department of Reserve Bank of India, Central Office in Mumbai."

Global trade invoices in INR

Few global developments have compelled India to take a decision to promote global trade in the Indian rupee. The US, EU, and the UK had imposed sanctions on major Russian banks from accessing the Society for Worldwide Interbank Financial Telecommunication (SWIFT) in the wake of the Russia-Ukraine conflict. What this meant for India was that export payments of nearly USD 500 million due from Russia were blocked. There were also substantial security implications. India is a net importer of goods from Russia. In the backdrop of the conflict, India has increased its imports of Russian crude oil. As per Reuters, India has bought at least 13 million barrels of Russian oil since February 24 this year. India is also awaiting the delivery of air defence systems, MIG 29 jets, and Su-30MKI aircraft from Russia. So, the announcement permitting international trade settlement in Indian Rupees by the Reserve Bank of India (RBI) earlier this month did not come as a surprise. However, no mention is made either of SWIFT or Russia in the circular.

India has experience in operating alternate payment mechanisms to settle dues in rupees instead of dollars. Article VI of the 1953 India-Soviet trade agreement had a similar clause. The arrangement covered all commercial transactions and other payments as mutually agreed by the central banks of India and the erstwhile USSR. The purpose of this arrangement was not to circumvent any sanction but to conserve foreign exchange and promote exports. The arrangement was finally terminated in 1992, and it took a long time to liquidate the rupee balance. Similarly, India had a rupee-rial payment mechanism with Iran when economic sanctions were imposed. This worked well to pay for some portion of our oil imports till product-specific sanctions were imposed by the US, reported CNBC TV18

The imposition of sanctions and the exclusion from SWIFT by the US could trigger a faster de-dollarization as countries displaying diplomatic and economic autonomy will be wary of using US-dominated global banking systems. The US dollar, which is the world's reserve currency, can see a steady fall in the current context as leading central banks may look to diversify their reserves away from it to other assets or currencies like the Euro, Renminbi, or gold. India's decision to encourage trade in INR may be a small step in that direction.

Challenges to rupee trade

Trade experts believe that the RBI circular on rupee trade is a little step forward but nothing more. According to them the transactions in INR shift the entire exchange rate risks to the foreign party. It is difficult to fathom why any foreign trader would agree to that.

Use of INR in international trade settlements is expected to gradually contribute to the global acceptance of rupee for international trade transactions. However, this move by the RBI demands close scrutiny, considering the ever-changing nature of global trade transactions. To promote the rupee for international trade settlements, the first step should be that India increase exports and imports so that the rupee becomes a highly tradable currency. This should be supported by critical reforms in financial markets, which include capital account convertibility, deepening financial markets coupled with large financial institutions other than the RBI to manage the large-scale inflow and outflow of capital.

In a Businessline report, trade analysts (Kasture & Singh) believe that three issues deserve prominent attention in the RBI's decision to allow international trade settlements in the rupee. First, international trade transactions, to be settled in the Indian rupee, need to be analyzed from bilateral trade equilibrium to understand their potential scope and scale. For example, in 2021, India's exports to Russia were at USD 3.3 billion while its imports from Russia were at USD 8.6 billion. This means that international trade settlement in rupee can happen up to USD 3.3 billion where exports and imports are equal. Beyond this point, international trade settlement in the rupee can be challenging.

However, the RBI has given the flexibility that additional surplus generated through exports by partner countries can be invested in Indian government securities and bonds — without considering the fact that the rupee is not a convertible currency. Therefore, investment in government securities and bonds cannot be repatriated. Moreover, this could potentially create macro-economic imbalances

and possibly lead to a situation in the long run where India's trade deficit is financed with the surplus investment of trading partners in government securities and treasury bills.

Second, the international trade transactions that take place between countries are shaped by various factors such as political and economic relations, availability of goods, quality and competitive pricing, etc. The exchange rate happens to be one of the factors in deciding trade. All elements have to be examined seriously which directly impact the landed cost for importers.

Third, India's efforts to promote invoicing in the Indian rupee and the acceptance of exchange with various countries are herculean tasks. Amid prevailing global trade protectionism and geopolitical rivalries, each country wants to promote exports and reduce imports.

Global debt crisis

There is a global debt crisis coming – and it won't stop at Sri Lanka, warns Jayati Ghosh (The According to her, the sad truth is that "investor sentiment" moves against poorer economies regardless of the real economic conditions in specific countries. Private credit rating agencies amplify the problem. This means that contagion is all too likely, and it will affect not just economies that are already experiencing difficulties, but a much wider range of low and middle-income countries that will face real difficulties in servicing their debts. Many countries with lower per-capita income and significant absolute poverty are facing stagflation. Billions of people are increasingly unable to afford a basic nutritious diet, and cannot meet basic health expenses. Material insecurity and social tensions are inevitable.

She believes that the situation can still be resolved, but it requires urgent action, especially on the part of the IFIs and G7. Speedy and systematic debt resolution actions to bring in private creditors and other creditors such as China, are needed. In addition, policies to limit speculation in commodity markets and profiteering by big food and fuel companies must be put in place. Finally, the recycling of special drawing rights (SDRs) – essentially "IMF coupons" – by countries that will not use them to countries that desperately need them is vital, as is another release of SDRs equating to about USD 650bn to provide immediate relief. Without these minimal measures, the post-Covid, post-Ukraine global economy is likely to be engulfed in a dystopia of debt defaults, increasing poverty, and socio-political instability, reported The Guardian.


India is already in stagflation – with a high rate of inflation and unemployment. Short-term monetary measures to increase the inflow of foreign money will not work. To get out of this crisis, which is likely to be intensified with the further outflow of foreign money, India needs long-term policies on food and energy. Shortage of chemical fertilizer due to the gas crisis will

have a negative impact on food production. Rice export from India should also be banned. Secondly, the government should impose restrictions on the distribution of petroleum products used for non-essential purposes. Railways must be given much higher priority than road transportation which consumes more fuel.

The government must focus on job creation activities. This is essential for sustaining the minimum livelihood of millions of unemployed citizens. Due to the global recession, the export market may shrink. New domestic markets should be developed instead. 'Make in India' has failed. The government may be advised to change the strategy to 'Make for India'.

Views expressed are personal

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