"If the country has high fiscal deficit and high inflation, and also has high current account deficit, I don't see why the currency will not depreciate," Reserve Bank of India Dr K C Chakrabarty told reporters on the sidelines of an event hosted by the Central Bank of India and the SME Chamber late last year.
Dr Chakrabarty's views are spot on, and reflects the deteriorating state of the Indian economy, which is playing on the Indian rupee. Up until the same time last year, India was amongst the most favoured nations for investments and the currency was easily amongst the better performing Asian currencies. Today, the currency has hit a low of Rs 53.41 and is not too far from historic low (intra day) of Rs 54.32.
Economic fundamentals have deteriorated dramatically giving rise to the fall of the rupee. Take the first case pointed out by the Deputy Governor of high fiscal deficit. In his Union Budget for 2011-2012, Pranab Mukherjee had estimated a fiscal deficit at 4.6% of GDP for 2011-2012. As he delivered his budget speech for 2012-2013 he has estimated that the fiscal deficit would be 5.9% of GDP for 2011-2012. The fiscal deficit has gone haywire thanks to mounting subsidies and populist policies.
The second reason as mentioned by DR K Chakarbarty is the high current account deficit, which has weighed on the rupee. In fact, the current account deficit will be the worst the country has seen in the last eight years. It's likely to come in at 3.5% of GDP. Inflation too has added to has added to weakening fundamentals by keeping interest rates at elevated levels, giving rise to a rising fiscal deficit, and lower revenue mop-up.
In the last three months, the staggering inflows from foreign institutional investors (FIIs) had prevented the rupee from sliding. In fact, FIIs invested as much as $9 billion in equities which kept the rupee from depreciating. However, these flows have dried up and in April FIIs were net sellers, which has added to some pressure on the rupee.
Going forward unless the government initiates reforms and keeps the fiscal deficit and inflation under control, it is unlikely the rupee will appreciate anytime soon.