Part 1- The Rupee Crunch: Reconciling theory with reality

The recent Rupee crunch has emerged as one of the most significant economic phenomenon of our time. In the midst of all the chaos, competing views have been offered without any attempt to bind these arguments coherently. It seems to me that these disparate views are merely an attempt for each party to absolve themselves of the blame of being the major contributing factor to the crunch. As an observer to this unfolding phenomenon I feel a professional obligation to submit some unbiased opinions.

At the surface, there is general awareness and consensus on the basic explanation that the crunch was a result of the current account deficit with India or to put it simply Import value outstripping Export value. I shall attempt to deviate from the normal arguments by binding the ones already offered coherently in a theoretical framework of analysis.

It is essential to begin by highlighting the difference between Bhutan and other economies. This is because it helps us understand some of the stabilization mechanisms that we have forgone albeit with good intentions and proven benefits. Most other countries trade with multiple partners and running a trade account surplus with some partners and a deficit with others is inevitable. Even a formidable trading country like China does not run a surplus with all its partners. Bhutan is constrained by geo-political and economic factors to trading predominantly with one country- India, and a surplus with India at this stage is inconceivable. Hence, we cannot rely on the stabilization mechanism accorded by trading with multiple partners.

Breaking it down further, a current account deficit with a trading partner essentially implies that the demand for the partner country’s currency exceeds its supply. In a fluid foreign exchange market, this would lead to upward pressure on the exchange rate of the partner currency making the home country’s exports cheaper and more attractive and the partner country’s exports more expensive, automatically restraining imports from the partner country.

However, given the peg between the INR and BTN this avenue cannot be considered. But maintaining the peg is not necessarily an ill-advised policy option at this stage. Perhaps with the full repayment of all our INR denominated debt obligations and an increased exporting capacity we could transition to a floating exchange rate regime. This would also enable more aggressive Monetary Policy pursuits.

Theoretically, a deficit in the current account is supposed to be offset by a surplus in the capital account. However, since Bhutan’s capital account is virtually closed in a de jure sense this is another mechanism that cannot be deployed. I emphasize de jure because there is an artificial capital account opening, which I strongly feel is a major contributing factor to the crunch.

To elaborate, it has been established that the staggering expansion in credit to the housing and construction sector is invariably linked to the crunch. A significant percentage of the credit to this sector eventually ends up in India, straining the central bank’s rupee reserves. Financial institutions have carved a significant share of their profits from lending to this segment of the market. While shareholders have reaped impressive dividends, the liquidity shortage from excessive lending to this sector has forced the Central Bank to borrow from the State Bank of India at 10% essentially subsidizing shareholders of Bhutanese financial institutions. The restriction on the capital account is distorting the flow of resources and the liabilities of the financial sector as well.

..to be continued