Just few years back, when global economic crisis hit the world, the country was in self congratulatory mode as it survived the disaster that supposedly much stronger western economies could not. However, things since then have taken an ugly turn as the rupee seems to be in free fall and now trades at Rs 56 versus US dollar, hitting the panic button. The value of a currency is a reflection of its current and future economic image. The country now stands exposed and visibility on near term catalysts to revive the domestic currency remains poor.
The main reason for this fall is twin deficit in the country. And what makes the situation worse is the timing. The current fall in rupee can't be compensated by attracting capital inflows as global appetite to invest in risky assets remains low. And unfortunately, the rupee seems to have fallen victim to a vicious cycle. Here is a simple example of how the cycle works. India to a huge extent depends upon imports of oil thus generating a huge oil import bill. With every fall in rupee, the demand of dollar versus rupee goes up thus mounting the pressure on the latter. And then, the fuel in India is sold at state determined prices leading to huge amount of subsidies. The outlow on subsidies lead to increase fiscal deficits thus feeding the cycle. Not just that, a higher value of imports stretches the current deficit further. While the Government at last has announced a hike in Petrol prices, it looks like a piecemeal solution to mend the gaping fiscal deficit. Unless the Government takes a tough stand on diesel prices, the situation is unlikely to come under control. This was just a simple example to show how lack of energy reforms impacts the rupee. One can guess what damage it does to the currency if you extend the example to other sectors including fertilizer, power, etc.
Now the question worrying most investors is as to how bad can it get? While balancing current deficit by attracting foreign funds could be a solution, it is easier said than done. A slew of corporate scandals and inaction on policy and reform front is keeping foreign investors at bay. Forget inflows of foreign funds, Indian markets are witnessing selling pressure and forex reserves are falling. Unless the Government bites the bullet and goes for economic reforms, hardly any strategy is likely to bear stable results. An action is long due with regards to reforms on subsidies, taxation, state run companies and increasing transparency and accountability. Anything less will amount of piecemeal intervention that might just smooth the fall but not avert it.