The USD-INR exchange rate is an important indicator of investor sentiment and can significantly impact not only the fortunes of individual firms and sectors but also the government. While this exchange rate has been very stable overall for the last five years, there have been periods of significant volatility. For example, USD-INR moved from 40.0 to 51.5 from March 2008 to March 2009. We believe there is a significant downside risk to USD-INR exchange rate and will explore some of the risk factors here.
Inflation is at an all-time high; the Consumer Price Index (CPI) increased by 10.88% in 2009 and by 13.19% in 2010. The monetary policy changes to control inflation have been ineffective. We believe this is because inflation is being driven primarily by structural supply side challenges such as lack of agricultural infrastructure, low crop yields, low organised retail penetration, and lack of import buffer for staples such as pulses where India is one of the main producers worldwide.
Unforeseen circumstances; like drought and unseasonal rains, compounded by structural problems related to demand-supply imbalances are affecting upward movement in food prices. Monetary policy initiatives cannot overcome these challenges. For instance, food inflation declined to single digits in November 2010, but increased again owing to unseasonal rains and supply chain problems that resulted in a rise in vegetable prices. The main food items that have driven inflation in recent times have been vegetables and pulses. The supply of these items has been unable to match demand, causing imbalances. Given the rise in global food prices, importing these items is not a feasible long-term solution. India needs to focus on the development of agriculture-related business and reduce interstate trade barriers to ensure the removal of the supply-demand imbalance.
Also due to the lack of good agricultural infrastructure, India has not been able to sufficiently increase food production. Yields in India are significantly lower than in other emerging countries. Government investments in large irrigation projects have been marred by corruption and execution delays. The private sector has been unable to pick up the slack due to an uncertain regulatory landscape and intermittent ad hoc government interventions. For example, the government has banned futures trading in several agricultural commodities, thereby killing what seemed to be a promising new sector. There are also yearly interventions either in the form of import or of export bans. These lead to high price volatility and deter private investments.
The standard of warehousing and transportation infrastructure for agricultural products is underdeveloped in India. Perishable items such as vegetables are damaged in large quantities before reaching the market. Recently, large quantities of wheat and rice were also found rotting in government stores in the state of Punjab; a major producer, because of improper storage.
The government has not opened up the retail sector for foreign investment - a huge roadblock in improving the supply chain of food items in the country, which is currently being developed only by limited private investment. Currently, retail in India is essentially unorganized; only 5% is organized with a major share accounted for by family-run stores. Gaps in the distribution systems lead to major differences in wholesale and retail prices. As a result, agriculture has continued to grow at a stubbornly low rate of 2% to 3%, barely keeping up with population growth. This is likely to keep food inflation high.
The combined central and state government deficit has stubbornly stayed around 10% of GDP. Concerns remain regarding the government’s ability to structurally reduce the deficit. Rising oil prices and resulting inflation could prove a further hurdle in efforts to control the deficit. Despite recent attempts to align the retail prices of petroleum products with international crude prices, considerable subsidies remain. Subsidy provisions in the budget are expected to fall short as the government has assumed very optimistic crude prices, and the cost of the National Food Security Bill to be introduced this year, will lead to an increase in social spending in 2011 to 2012. According to the speech given by India’s Finance Minister, social spending will increase by 17% in this fiscal year. This makes it even more difficult to bring down the country’s fiscal deficit.
Another major concern is that 70% of India’s imports of oil and efforts to increase the production capacity of petroleum and natural gas domestically have not been very successful.
Efforts to develop domestic fields to meet the oil and natural gas requirements have not done well. The recent round of oil well auctions by the government attracted limited interest from international oil companies. Only 74 bids were received for 33 of the 34 blocks on auction. This reflects either unrealistic terms set by the government or a lack of investor confidence, and is a huge setback, especially because it takes at least two years to organize a round of auctions and then a few more before any oil is produced. Thus India’s reliance on expensive imported oil is likely to continue in the near and medium term. This leaves the economy exposed to the vagaries of volatile oil prices, specifically the sharp upward trends.
India’s current deficit is about 3%, the level it reached during the crisis of the 1990s. A current account deficit is not bad by itself for a growing economy if it helps build important long-term productive assets.
For a long time conventional wisdom held that a current account deficit is a necessity for growing economies. But China showed that it is possible to sustain very high growth without running current account deficits, achieving trade surpluses and high domestic savings that resulted in a current account surplus. In India’s case, both these factors are negative and hence there is a high current account deficit. The current account deficit by itself may not be a bad thing if it is used to build productive assets (e.g. roads, ports, electricity generation) that deliver long-term growth. Nevertheless, it is not clear that this is the case in India.
Unfortunately, some of the money already seems to be feeding speculative real estate activity instead. There has been a spectacular rise in real estate prices during the past two years, especially in large metropolitan areas such as Delhi and Mumbai, where both residential and commercial property prices have increased by 50% or more. This is exacerbated by the fact that the more volatile FII money and not the more stable FDI, is funding the current account deficit.
This risk is also heightened by the fact that India’s capital markets are very shallow and do not have the capacity to absorb even moderate external shocks. As discussed earlier in this article, in 2008 it took an outflow of only US$13 billion for the Indian stock market to crash by over 50% and the Rupee to depreciate by 30%.
India as one of the fastest growing economies should be a favoured destination for investment. Nevertheless, it witnessed a decline in Foreign Direct Investments (FDI) in 2010, making it the only BRIC country where this happened. This is troubling as FDI is an important indicator of investors’ faith in a country’s long-term prospects. Foreign Institutional Investment (FII) which provides short-term portfolio investment money inflows has been buoyant, but these funds are volatile by nature and are prone to ‘flight risk’, something that happened during the financial crisis.
Recent widespread corruption scandals have reinforced the negative perception of governance deficit in India. This combined with regulatory and tax uncertainty, will deter foreign investors. For example, several global firms who invested in India’s telecom sector have had to write off billions of dollars of their investments.
A major source of foreign currency inflows to India is remittances; India received US$55 billion in remittances during 2010. The Middle East accounts for a major share of this inflow and the current turmoil in the region may negatively influence it.
The United States (US) economy seems to be on the path to recovery. It is very likely that the improving US economy will draw more funds at the expense of emerging countries. This can already be seen in the FDI inflows, which increased by 43% in 2010.
These risks are also heightened by the fact that India’s capital markets are very shallow and do not have the capacity to absorb external shocks. In 2008, it took an outflow of only US$13 billion for the Rupee to depreciate by 30%. We believe that even a relatively orderly outflow of US$15 billion of FII money over a year could result in the INR depreciating by 22% to 30%. This would imply an exchange rate in the range of INR 55 to 60 to USD 1. It could get even worse if the flight of capital were to take place over a shorter period.
Ashutosh Gupta is the Vice President of Investment Research and Chief Transition Officer at Evalueserve. Prior to Evalueserve, Ashutosh was a Vice President at Goldman Sachs. He worked in several capacities at Goldman Sachs in New York and London including the New Products group and the Equities division. His last job was at the Equity Finance trading desk in London where he was part of a structuring team that put together large structured trades for corporations and financial institutions. Prior to Goldman Sachs, Ashutosh attended New York University Stern School of Business and before that worked as a consultant with Roy F Weston Inc., an engineering consulting firm in Philadephia, USA.
Surbhee Sirohi is a Manager in the Investment Research group at Evalueserve. Prior to joining Evalueserve, she worked with ICICI Bank in their Private Banking division. She holds a Post Graduate Diploma in Management with a dual specialization in Finance and Marketing, from Symbiosis Institute of Management Studies and a Post Graduate degree in Economics from Pune University.
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