Weak rupee increases India inflation dilemma 

(MENAFN - Arab Times) India's growth has been slowing down in recent quarters, and its currency has weakened. On the domestic front, India has been plagued by persistently high inflation, requiring the Reserve Bank of India (RBI) to keep interest rates at lofty levels, which has hurt investments and domestic demand.

The central bank cut rates by 50 basis points a few weeks ago in an attempt to boost growth, although prices are still increasing - a major problem RBI has been facing.

The balance of payments is also hurting India: on one hand, the trade deficit continues to widen; and on the other, the fragile financial account surplus is coming down due to weaker foreign capital interest. As a result, the Indian rupee has been depreciating, reaching its current historical low, past 56 rupees per US dollar. Given that India is a strong net importer, the weak currency has been fuelling inflation, mainly through energy imports, increasing India's dilemma of lower growth and stubborn inflation.

Gains
After a strong start of the year, the Indian Rupee already lost all its yearly gains, down 5% year-to-date, as the balance of payments continues to deteriorate. In response, the RBI and Indian authorities have taken steps to stabilize the Rupee. First, in order to boost demand, RBI intervened by (a) selling dollars and (b) carrying out open market operations, as well as (c) introducing new measures such as forcing exporters to convert at least half of their US dollar holdings in Rupee and increasing the interest rate on foreign currency deposits.

Second, with the purpose of encouraging foreign investment inflows, authorities delayed new tax regulations, and blocked proposed tax changes from overriding any of the over 80 double tax avoidance agreements (DTAA) of the country. RBI and the government's latest actions are expected to halt the fall of the Indian rupee.

The weak external balance of payments, which consists of the current account and the financial account, has been a long-standing issue in India, and has worsened in the last few quarters. The current account - which comprises the trade of goods and services, income and transfers - has traditionally been in deficit.

This situation is exacerbated by the high oil price and the weak rupee, which makes goods abroad more expensive. This trend particularly hits India's oil companies that buy oil overseas and sell fuel at state-controlled prices. India finds itself spending more for the same quantity of goods and services, consequently hurting the currency as more rupees are sold to purchase US dollars.

The financial account, which takes into account the economy's foreign net capital flows (such as portfolio investments and foreign direct investment), also influences the foreign exchange of the Indian rupee: the higher the net inflows, the stronger the demand for rupees from abroad.

However, India's financial account surplus has been declining in the past few quarters, hence weakening the demand for the currency and fostering the depreciation in the Rupee.

Crisis
India is one of the most domestic-oriented economies in Asia. So, in theory, the European crisis should have a less significant effect on the country than on its Asian peers. However, the nation's strong demand for energy from abroad (80% of what it consumes) affects the country in its own way. As the rupee and the current account deficit fall, fuel subsidies weigh more on the government's expenses deteriorating the fiscal deficit.

In reaction to the imbalances, the financial account declines as weaker investor confidence drives the outflow of funds. Given the current fragile economic climate, a risk-off environment could spur further outflows.

Despite fundamentally adverse effects from the weakening rupee, the next few months could very well be the best time to enter India. To start with, the current level of the Rupee should help the export sector become more competitive and help reduce the trade deficit. Also, the weak currency could attract investors, by both holding the oversold currency expecting future appreciation and buying cheaper rupee-denominated capital.

Excluding any major euro zone collapse, RBI's actions, as well as investor interest in distressed assets, are likely to bring the Rupee back to stronger levels, which could gradually become a supporting factor to curb inflation and reinvigorate the Indian market.