One of the stupidest myth attributed to FDI in Retail is that it will make Rupee stronger. People who say this have absolutely no idea or are just out there to make fool of others or are just delusional. FDI in Retail is not going to make Rupee any stronger.
Rupee strength due to FDI in Retail can only occur in two case, either FDI is enormously successful with large number of players entering the market, thus displacing massive number of local retailers and / or if the MNC retailers use India as their hub to source the SKUs for their international operations, which would be a good case..
Why Strong Rupee?
The first question to ask is: Why do you need a strong Rupee?
Rupee is just a medium of exchange, and if all things being equal it will help Indian economy clean up its mess by enabling efficient capital allocation. I.e. for example, in case of weak Rupee, capital / business will shift from import intensive to export intensive.
A country deciding where it wants to peg the currency band is a very important step. The price band where the Central Bank is comfortable determines how and where they want the capital to flow and outflow. Its effectively choosing how much of exports and how much of imports is to be encouraged and subsidized*.
The question now is, why does India need a strong Rupee? The simplistic answer is, because the government expects the imports to be more than the exports. Therefore despite the Crude oil and Gold imports, government has no confidence that exports will perk up anytime. That guess may be right as most of our consuming nations are in or near recessions. Hence, a strong Rupee would be a wonderful in bringing down the costs of energy and inflation-hedges (gold).
So the subsequent question is: Why is Rupee so vulnerable to weakness? The short and sweet answer is because our dear economy is totally screwed. And no it is not due to global factors. Rupee is weak because government has been comfortable doing nothing over an inordinately long period of time. Now, the karma comes home.
Government is trying to short cut the mess by pawning its crown jewel viz. Retail Sector, with absolutely no concern or care for what and what social pandemonium it will create.
And this is the worst part: If the government’s goal is to strengthen Rupee by allowing the FDI interests in Retail sector, we can be very very very sure they will fail!
Long story short: Rupee in unlikely to appreciate in short term. Or even in long term, as FDI in retail is no panacea for poor business environment and growth. (Explanations given below for the interested)
To understand the reasons, lets first understand few basics for forex flows. Firstly, the strength of a currency is directly dependent on:
- Strength or Weakness of the counter currency
- Interest Rate Differential
- Demand for the currency at any point of time
These three points pretty much encapsulate everything that is required to know on the crux of forex flows. The other reasons are just elaboration and variations of these.
- Strength
The Counter currency for all practical aspects is Dollar. Therefore, when the Rupee is stronger, Dollar weakens; and when Dollar is stronger, Rupee weakens. Hence, Rupee’s fortunes are very closely linked to Dollar's.
Dollar has its own reasons why it should be stronger or weaker. Or more precisely, why Dollar will be stronger or weaker against its principal trading partners like Europe, Japan, UK and Canada. Therefore, by seeking a stronger Rupee, India’s fortunes are now indirectly being pegged to the fortunes of these principal trading partners of USA. I.e. India is betting that Europe, Japan and others will exert enough weight that Dollar will remain down while other currencies (including Rupee) will rise against it.
Unfortunately, if this argument was a boat, it will would a million holes. Europe, for all practical purposes, is heading into one massive sovereign bankruptcy and probably may even cease to exist. The only reason why Euro is still has head above water is due to the liquidity onslaught by its Central Bank / ECB. And this is grossly a temporary measure. Even Europeans don’t believe this will last. (Japan’s Yen has a major influence but not in straight forward way as explained above. Hence I will skip it.)
There is no counter weight in today’s’ economic scenario which can keep the Dollar down, if European situation even slightly haywire. The funny thing is, even if US were to get into trouble, a much larger trouble than it is in already, Dollar will strengthen further and not fall.
Therefore to conclude, wanting to have a strong Rupee when Dollar is all set for a secular uptrend is asking for the impossible. If the strong Rupee is the reason, purportedly, for FDI in Retail, this will be a spectacular failure.
- Interest Rate Differential
Interest Rate Differential has huge impact in world flooded with liquidity and looking for yields. But betting on this tactic, is to make Indian Rupee a carry trade currency. And it is unlikely to end well. RBI is unlikely to follow this tactic at all but for academic interest, here we go.
Interest Rate Differential simplistically means, people borrow in a country with low interest rates and invest in bonds of countries with high interest rates. For instance, if a corporate can take a loan at 3% in developed country and invest it at 9% in India, the player makes a neat cut of 6%. This is a carry trade.
Though this is a very good trade, there are risks associated with the trade. The main risks are:
- Interest rates
- Currency Fluctuations
- Inflation
- Fiscal deficits
1. Interest Rates
For India to use this tactic to hold a strong Rupee is to keep interest rates high for a long time. Interest rates are already very high for a long time now; keeping it here would hit local businesses very badly.
This is unlikely to happen, and IR may be reduced in future, hence it may not be the best time to initiate a carry trade.
2. Currency Volatility
The player also has to consider the possible Rupee – Dollar fluctuations to manage the trade. Hence, the Rupee has to be a tight manageable band; else players just unwind the trade. RBI does not have wherewithal to fight currency flights, hence managing the Rupee levels is an unviable position.
3. Inflation
Another clear risk is Inflation. By buying Indian bonds, the trader also buys Indian inflation. Hence the net income for the trader is interest rate differential minus inflation. Though a low inflation is a good thing, it would also mean keeping the credit off-take low and interest rates high.
4. Fiscal Deficit
High Fiscal deficits weaken the currency, and also the new issuances of bonds, hence this is effectively an government deleveraging. Government deleveraging for an economy like India is very bad.
- . Demand for the Currency
As you can see from the above two, there are lots of hurdles to strengthening the currency. The easiest and the best way is to improve the domestic businesses environment where the natural demand for Rupee is increased and hence Rupee strengthens automatically or at least is not vulnerable to global cues. This is where the Government’s karma of past 8-years continues to haunt.
Rupee is weakest and most vulnerable than it has ever been. A slight trigger in global panic and Rupee will crash, which is possibly what is intended to be avoided, but unfortunately its too little too late. Only saving factor would be if we have enough time from now and the trigger.
Aside:
It would actually be a good bet to bet on Rupee to be around 64 against Dollar before March 2013. The run may especially begin in November and December this year, as the primary buoyancy factor - the US Presidential elections would be out the way, and reality will return along with the year-end profit-taking and re-allocation.
On a long term too, Rupee is unlikely to strengthen from the present level unless India is able to recapture the growth trajectory above 7-8%
*Subsidy: Cost borne by one for the benefit of other.
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