Indian economy is passing through a tricky phase with rupee registering its lowest record against the dollar. During 2018, the rupee has depreciated by more than 15 per cent, putting pressure on the Reserve Bank of India (RBI). Rising crude oil prices and the huge outflow of capital from the Indian market are cited as the two major factors contributing to the depreciation of rupee.
Foreign investors losing interest and pulling out their funds from the Indian market can be seen as the major factor behind depreciation of rupee. The unconventional monetary policies that has been in practise in the developed economies for more than a decade now, has greatly influenced the movement of currencies in the emerging markets.
After the dot-com bubble in 2001 followed by the sub-prime mortgage crisis in 2008, the US economy slipped into a deflationary trap. Federal Reserve slashed interest rates to zero and even resorted to quantitative easing to pump money into the economy. The cheap dollar meant to revive the US economy were not restricted within the boundaries of US. Thus, dollar fled to the emerging markets in search of better returns, with India being one of the most preferred destinations. At the same time, India also benefited from the inflow of dollars with forex reserves surging heights. Foreign exchange reserves of India increased from $ 251.98 billion in 2008-09 to $369.95 in 2016-17. The capital that was flowing into the economy, categorised as ‘hot money’, was in search for better profit from the interest rate differences. However, there was no warranty that this capital will be in the economy for a longer period.
The sudden withdrawal of capital can cause huge repercussions to the domestic economy. For instance, in 2013 when the then Fed Chairman Ben Bernake hinted about an interest rate hike, popularly known as the ‘taper tantrum’, it created a turbulence across the emerging economies. India was also not immune from the taper tantrum, since it is categorised as one of the fragile five economies, apart from Brazil, South Africa, Turkey and Indonesia.
The present situation, although not as worrying, is similar to 2013. With the signs of recovery in the US economy, the Fed wants to return to the normal path of monetary policy by withdrawing from quantitative easing and zero interest rate. In this line, the first rate hike was announced in 2015, after maintaining the interest rate at zero for more than a decade. Since then, rate hike has been rising in a smooth manner without greatly affecting the emerging markets. With Jerome Powell taking over as the Fed Chairman in 2018, a more aggressive stance on rate hike is expected in the coming years. The market already gauged it correctly, resulting in a huge outflow of capital from the emerging markets. As seen, in 2018 foreign investors have already withdrawn around ₹ 90,000 crores from the Indian market.
The question that arises at this juncture is what could be done to arrest the fall of ₹? In this present scenario, RBI will only have a limited role and any step taken by the Central Bank to retain the foreign investors will find resistance from domestic businesses. For instance, to retain the foreign investors RBI could raise the interest rate but that would not go well with the domestic businesses with the cost of credit going up.
In the present circumstance, India should focus on attracting long-term foreign investments rather than short term. The focus should move from attracting Foreign Portfolio Investment (FPI) to Foreign Direct Investment (FDI). FPIs can provide a cushioning effect but there should be a long-term foreign investment that could help in soothing the economy from the corollaries caused by the hot money.
FDI will encourage more inflows to the country leading to increase in demand for ₹, and raise its exchange rate. The increasing demand for ₹ in turn will help in arresting the fall of ₹. The present government has made considerable steps to attract more FDIs. For instance, abolishment of the Foreign Investment Promotion Board (FIPB) announced in the budget of 2017, was to help minimise the delay in getting approvals. However, the policy reforms have not offered comfort to the foreign investors.
When FDI to India is taken into account, it can be seen that there was a decline from $44 billion in 2016 to $ 40 billion in 2017. It is a matter of serious concern that India’s improvement in the ease of doing business has failed in generating an enthusiasm among the foreign investors. Clearly, this shows that there is a need to rework on the FDI policy and more sectors need to be opened to make it attractive to foreign investors. The government should also work in bringing more clarity in tax regime as it is imperative in attracting investment. Moreover, any investor will be looking for a policy consistency and India should work towards achieving it.
FDI will not only help in soothing the currency fluctuation but will be a boost to the domestic economy as well. Foreign investors will bring with them new technologies, and the investments made by them will help in employment generation. Job creation is one of the major challenges faced by the country today and more investments will help in addressing this issue. It is high time that the government pulls out a serious plan on attracting FDI to the country.