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Slip sliding

There are no instant solutions to revive the rupee. Govt must initiate a new round of reforms

Written by The Indian Express | Published: May 4, 2012 3:07 am

There are no instant solutions to revive the rupee. Govt must initiate a new round of reforms

The downward pressure on the rupee has led to a further slide in its value. The RBI has reportedly intervened to support the rupee. In the past four months,it has consistently stepped into the foreign exchange market,selling dollars and preventing sharp rupee depreciation. However,as the pressure on the rupee has continued,the RBI has stepped in only on days when it has moved sharply,rather than supporting the rupee at a specific level as that could have turned into an ugly speculative attack,and India could have lost all its reserves in a matter of days.

The depreciation of the rupee is a consequence of the weakening macro-economic fundamentals of the economy. India today has a historically high current account deficit at 4 per cent of the GDP. At first blush it may appear to be the difference between imports and exports,but a deeper explanation lies in thinking of the current account deficit as the difference between what a country produces and what it spends. When it spends more than it produces,it consumes goods produced abroad. The net balance shows up as the deficit on the current account. Often termed a twin deficit problem,if the government runs a high fiscal deficit,it increases the current account deficit.

Since the 1991 crisis,India has been running a current account deficit of around 2 per cent of the GDP. The liberalisation of the capital account allowed this deficit to be financed by private capital flows. Today,foreign private capital flows have slowed down. This means there is a mismatch in the currency market,putting pressure on the rupee. Unless capital flows pick up,the rupee will feel more pressure to weaken. Supplementing private capital flows by borrowing abroad would be a bad idea,however,as it would increase public debt,this time in dollars. The resulting signal of panic in government may push private investment down further. Inflation,fiscal deficits and poor governance may make India an in- creasingly unattractive destination for foreign investors. The solution is not in selling reserves or raising customs duties on imports. The government should cut the fiscal deficit by reducing subsidies on oil and fertilisers and reduce the risk of a balance of payments crisis.

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