Moody's Investors Service says that the depreciation of the rupee will exacerbate inflationary and fiscal pressures in India (Baa3 stable) and pose additional constraints on the monetary policy response to the current growth slowdown.
Moody's just released report titled, "India: Answers to Frequently Asked Questions About the Credit Impact of Rupee Depreciation" notes that the fall in the exchange rate, by increasing the domestic prices of imported goods, will contribute to inflation as well as to an increase in the government's expenditures, including on subsidies. It will also raise the cost of servicing foreign currency debt for several firms.
However, it will not increase the government's own debt repayment burden significantly because only 6% of the government's total debt is denominated in foreign currency. Also, given the relatively low reliance on foreign currency debt by the majority of the private sector (non-government external debt is estimated at 16% of GDP), the growth impact of depreciation will be more moderate than in a highly externally indebted economy.
The report points out that steep rupee depreciation is not unprecedented and that the exchange rate reflects the growing interface between domestic and global trends as India's trade and financial openness increases. Benign global liquidity conditions and high domestic growth supported an approximately 18% appreciation of the INR against the USD between 2001 and 2007. Then, international financial volatility contributed to the INR depreciating by 27% against the USD over the course of FY2007-08.
A combination of global and local factors has underpinned the roughly 17% INR depreciation against the USD over the last two years. Loose fiscal policy, relatively high domestic inflation and soft global export demand has widened India's current account deficit over the last two years. Meanwhile, international financial uncertainty and India's own subdued growth outlook has lowered capital inflows over the same period. The steep decline in the currency's value over the last two months coincided with heightened international risk aversion stemming from the anticipated tapering of US Federal Reserve bond purchases.
Moody's expects that measures undertaken in recent weeks, including those to adjust rupee liquidity and increase foreign capital inflows, could arrest the pace of depreciation. However, the chances of significant near term appreciation this year are limited given the extended growth slowdown, continued global financial volatility, and domestic political uncertainty ahead of 2014 national elections.