Economic Gloom Deepens as Rupee Fuels Inflation

India's economic gloom deepened on Wednesday as figures showed a record low rupee is adding to Reserve Bank of India's (RBI) inflation headache and an adviser to the prime minister said there was little that could be done to check the currency's slump.

An 18 percent slide in the value of the rupee since July is adding to a growing worry of economic crisis in the country as stubbornly high inflation ties the hands of the central bank from easing policy to try to turn a grim economic outlook.

A worsening fiscal picture means the government's financial firepower is also limited. Parliament is in gridlock, preventing approvals for investment that could help offset a ballooning current account deficit.

Indeed, C. Rangarajan, chairman of the Prime Minister's Economic Advisory Council, suggested there were little policymakers can do to counter the slide in the currency.

He said the rupee was subject to the whims of global investors, who are buying the dollar as a safe haven from the euro-zone debt crisis.

The behavior of the rupee is also a reflection of the behavior of the dollar, he said. There is very little that can be done.

Data on Wednesday showed wholesale prices, the main gauge of inflation in India, rose 9.11 percent in November from a year earlier. That showed inflation actually fell from 9.73 percent in October thanks to a sharp pull back in food price pressures.

However, fuel inflation rose to 15.48 percent from 14.79 percent and manufacturing inflation increased to 7.7 percent from 7.66 percent as the tumbling rupee pushed up import costs.

RUPEE SLIDE

The slide in the rupee has caught policymakers flat-footed and by firing up import costs it is undermining the RBI's forecast for inflation to drop to 7 percent by March. That potentially pushes back when the central bank could ease policy.

The rupee fell to a fresh low of 54 per dollar on Wednesday.

Many economists believe it will fall further, in turn keeping downward pressure on Indian stocks, which are off 22 percent in 2012, among the worst in Asia. The main index fell 0.76 percent on Wednesday.

The bearish sentiment is very strong and there is nothing going for the rupee, said Hari Chandramgathan, a foreign exchange dealer with Federal Bank.

While the central bank has stepped in to smooth volatility in the foreign exchange market, it has not mounted a spirited defense of the currency and is not expected to do so given limited reserves and the need to fund a swelling trade deficit.

Central bank has a limited flexibility, but I think they should intervene, said M. Govinda Rao, a member of Prime Minister Manmohan Singh's economic advisory team.

RBI can intervene, but since the balances are not large, there is a serious problem. RBI cannot be immune to that, he said, adding that one possibility is to raise interest rates on deposits of non-resident Indians.

The current account deficit hit $14 billion in the April-June quarter; nearly triple the previous quarter's tally.

The risk is that a plunging rupee will be seen by investors as reason enough to pull capital out of the country, adding yet more downward pressure on the currency and setting off a balance of payments crisis.

Deutsche Bank said in a Nov 24 report that now is India's time of reckoning and UBS said investor sentiment has gone from cautious to outright scared.

The rupee is vulnerable because external debt payments of about $20 billion are due in the first half of 2012 and because importers are not effectively hedged, said Sailesh K. Jha, head of Asia strategy at Skandinaviska Enskilda Banken in Singapore.

We anticipate continued net outflows from the equity market into first half of 2012 as the uncertainty on the outlook for India growth, inflation and macroeconomic policies lingers, said Jha, who expects the currency to touch 57 in the first quarter of 2012, with 60 possible in the first half.

TOUGH TIMES

India's economy has been battered by local setbacks and global headwinds. The government had originally projected growth of 9 percent in the fiscal year to March 2012.

Now, analysts say India will struggle to grow even 7 percent, a sharp drop from 8.5 percent in 2010/11.

Such forecasts were supported by data on Monday showing India's industrial output slumped more than 5 percent in October from a year earlier, far worse than expected and the first fall in over two years.

Central banks elsewhere in the world, including in China, Brazil and Indonesia, have started to ease monetary policy as dark economic clouds gather globally.

India's central bank will not be able to move so fast.

Headline inflation has been above 9 percent for 12 consecutive months despite 13 rate increases since March 2010 that have lifted the repo rate -- the policy rate -- to a three-year high of 8.5 percent from 4.75 percent.

While November's inflation was the lowest in a year, it brought little joy to investors, who pushed up bond yields and swap rates.

The central bank indicated in October that further rate rises may not be needed if inflation comes down, raising hopes in India that rates might start to come down, but the rupee's drop complicates that.

The rapid depreciation of the rupee is going to throw out of the window all the calculations on inflation, given the contribution of imported inflation to manufactured product price inflation, said Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai.

The central bank reviews monetary policy on Friday, but with inflation stubbornly above 9 percent it is widely expected to keep rates on hold.

Even though the RBI will definitely pause on rates, the exact timing from which it would have started easing interest rates has once again turned uncertain due to the tumbling currency, Nitsure said.

Tight cash conditions in the money market have fuelled speculation that the central bank might lower the cash reserve ratio, the percentage of deposits banks must maintain with the RBI, as early as Friday. However, a Reuters poll showed economists don't expect a CRR cut before 2012.

The RBI is unlikely to jump the gun either on CRR or on the repo rate just yet. I think these are both early next year outcomes. But on Friday what it will do is it will sound a lot more dovish. That in itself is an important change, said Rajeev Malik, an economist with CLSA in Singapore.