Weak and vulnerable

Ben Bernanke, Chairman of the U.S. Federal Reserve, has suggested that the era of “quantitative easing” is nearing its end, which could mean that capital inflows to India will slow down.

WHEN the rupee crossed the 60-to-a-dollar barrier on June 26, official and corporate concern was palpable. This was not because everybody was a loser in this game. Exporters, especially those locked into longer-term deals struck in dollars and those looking to expand sales by holding rupee prices (and therefore reducing dollar prices), would benefit. If yet, the mood of concern was more generalised, the reason was that after slow growth, persisting consumer price inflation and a difficult balance of payments situation, the depreciation was one more indicator that the post-2003 boom was a short-term episode rather than a sustainable new trajectory of high growth. It was not just the rupee but a whole growth story that was in question.

The government on its part should have expected the rupee’s decline. Although fluctuating, the ratio of India’s current account deficit to gross domestic product (GDP) has, since the beginning of financial year 2009-10, been unusually high in most quarters (Chart 1)—well above the levels that the ratio touched at the time of the balance of payments crisis in 1991. Having peaked at 6.7 per cent during October-December 2012, the ratio is estimated to have remained at 4.8 per cent in the last quarter of 2012-13. India, over the medium term, has spent far more foreign exchange every quarter than it has earned through exports and through other routes such as remittances. This was true even for the years well before the 2008 crisis although the deficit has tended to widen sharply in recent times as a result of large payments for imports of oil and gold.

Persistent current account deficits are conventionally the basis for the weakening of a country’s currency. In the past, expectations were that the resulting currency depreciation, by raising the rupee value of imports and dampening demand for them, would help correct the imbalance. But in India’s case more recently, structural factors, embedded in the kinds of demands that inequality generates, have meant that currency depreciation has neither reduced demand for foreign exchange nor its outflow on account of imports of petroleum products and gold, despite increases in prices and/or duties, besides the cost increases resulting from currency depreciation.

Rupee and capital flows One reason why the government could afford to ignore this adverse trend on the external payments front was that India was favoured by large capital inflows, which were more than what was needed to finance the current account deficit. Like many other developing countries, India too became a victim of the dollar-carry trade, in which international players borrowed in dollar markets, where liquidity was ample and interest rates low, and invested in equity, debt and real estate in developing country markets, where returns were high, in order to make huge profits from the differential between the cost of debt and the return on investment. The net result was an asset market boom and an appreciation of the target country’s currency, the feedback effects of which only increased the volume of inflows, leading to a capital inflow surge.

On more than one occasion, emerging market countries, stretching from Thailand to Brazil, have complained about the adverse effect of the United States’ loose monetary policy on their currencies and their export competitiveness. Inasmuch as the surge in capital inflows results in the accumulation of legacy portfolio capital in these countries, creating the possibility of a sudden and destabilising exodus of capital, that adverse effect is long term in nature.

In India, too, over much of the last decade, capital inflows have been well in excess of the current account deficit. In fact, even when the crisis hit the developed countries, after a short period in which India experienced a net outflow of capital, the infusion of liquidity by developed-country central banks restored flows into India. As a result, in every quarter starting with the second quarter (July-September) of 2009-10, and until the second half of 2011-12, inflows exceeded the deficit on the current account of India’s balance of payments (Chart 1). As a result, during the second half of 2009 and throughout 2010, the rupee appreciated vis-a-vis the dollar, even if by a small proportion.

However, since July-September 2011, while the current account deficit has been high and rising, touching 6.7 per cent of GDP during the last quarter of 2012, capital inflows have either fallen short of or just about matched current account financing requirements. This had put downward pressure on the rupee, as had happened even earlier. In fact, during the second half of 2011, the rupee depreciated by as much as 19.5 per cent vis-a-vis the dollar and 14.4 per cent vis-a-vis the pound (Chart 2). Even then, fears that capital inflows may dry up and force a reduction in reserves seem to have played a role in the rupee’s depreciation. The medium-term economic situation seems to warrant the depreciation of the rupee, and even moderately good capital inflows have not helped stall that decline. This points to a high degree of vulnerability.

The fluctuations But the role of capital flows in influencing the relative value of the rupee has meant that, despite persistent current account deficits, the rupee’s value has fluctuated. Thus, in April-June 2011, the rupee was at a high vis-a-vis the dollar and set off concerns about the currency’s overvaluation. The rupee had weakened during the financial crisis, when foreign portfolio investors chose to book profits and take money out of the country to cover losses they had suffered or commitments they needed to finance at home. From less than Rs.40 to the dollar in April 2008, the rupee fell to Rs.52 to the dollar at the beginning of March 2009. But, thereafter, once central banks in the U.S. and elsewhere in the developed world chose to infuse cheap liquidity into the system as a response to the crisis, capital once again started flowing into emerging markets.

The resulting appreciation of the rupee, many argued at that time, was adversely affecting the competitiveness of India’s exports. There was much pressure on the central bank to intervene to prevent appreciation by buying dollars and augmenting its foreign exchange reserves, and there was criticism that it was not doing enough on this front. The appreciating trend continued for some time. But from around August 2011, the rupee has been depreciating on average, despite brief periods of appreciation in January and September 2012.

Rising external debt This medium-term decline is disconcerting because in this period the U.S., and some other central banks, continued with a policy of “quantitative easing”, or the infusion of cheap money into the system. In fact, countries such as Brazil complained during those months that the U.S. was indulging in a currency war by engineering capital flows into emerging markets and driving up their currencies and adversely affecting their trade balance. The Indian government responded to the depreciation by resorting to a host of measures to attract capital, even in the form of debt into the domestic market. The result is that India’s external debt has risen by more than 13 per cent over the last financial year, with short-term debt accounting for a rising share. Yet, as noted above, aggregate net capital inflows have been either short of or just matched the volumes needed to finance the current account deficit, resulting in downward pressure on the rupee.

The Reserve Bank of India, too, appears reluctant to retrench a part of its foreign exchange reserves to stall the rupee’s depreciation. It possibly wants to avoid sending out the signal that India’s foreign reserves are under threat and invite a speculative attack on the currency. It is, therefore, permitting the depreciation with only marginal intervention through the sale of reserve foreign exchange.

In the event, any trigger is enough to set off a downward spiral that also renders the currency vulnerable to a speculative attack. Not surprisingly, the rupee’s recent decline has been attributed to U.S. Federal Reserve Chairman Ben Bernanke’s suggestion that the era of quantitative easing is nearing its end. Since any such move would trigger a flow of funds into the U.S. or to the safety of dollar-denominated assets, the fear is that inflows to India will slow down and investors may even pull out. However, too much should not be made of such speculation. The fact of the matter is that the rupee has weakened against most currencies and not just the dollar. Over the first half of 2013, while the rupee has depreciated by 10.5 per cent against the dollar, it has fallen by 4.1 per cent vis-a-vis the pound and 8.9 per cent vis-a-vis the weak euro as well.

In sum, the weakness of the rupee is a result of the deterioration in India’s economic performance, especially the deterioration of its balance of payments. Such weakening in an economy that, through liberalisation, has made itself dependent on foreign finance only leads to heightened instability. Already there are fears of the depreciation stoking another bout of high inflation, especially if the government sticks to its policy of adjusting domestic prices, of fuel, food and much else, in tandem with international, dollar prices. Public confidence can be restored only if the dependence on capital inflows is reduced through appropriate adjustments in policies with respect to trade and foreign capital inflows. But that, it seems, will require a different government.