Pressure on policy

The Moody's decision puts pressure on the Government to refrain from responding appropriately to the crisis in South Asia and to signs of instability in the value of the rupee.

MOODY'S Investors Service Inc., the international ratings agency, like its competitor Standard and Poor's, is still smarting from the year-end bashing it took in East Asia. So when it got down to work early in January, with its attention focussed on Asia, it chose to take on a weak link in the region - India. The agency declared that it was undertaking a review of India's sovereign rating, with a view to a possible downgrade. With Indian bonds already rated at 'Baa3', the lowest in the medium grade category ("which are neither highly protected nor poorly secured"), such an action would place them in the speculative category, below investment grade.

The immediate provocation for the move was extraneous. All international ratings agencies were upbeat about the East Asian countries and their financial institutions when the currency and stock market crises began to sweep across the region. With the crisis proving severe and showing no signs of abating, these agencies were forced to follow market trends and cut ratings sharply. The most dramatic ratings shift occurred in the case of South Korea: from a highly-rated country, it was reduced to near-junk-bond status virtually overnight. For investors making investments based on agency ratings, these moves amounted to too much, too late. Too late, because the new ratings followed the collapse in the markets rather than precede them. Too much, because the knee-jerk reaction served as one more factor that contributed to the continuing slide in the East Asian markets. Faced with a downgrade in the middle of the crisis, Korean financial entities and the Government found it impossible to raise credit offshore to service short-term debt obligations, pushing the won and a host of chaebols (conglomerates) down even further. Investor anger at and disillusionment with the ratings agencies were a consequence.

Having sullied their image in East Asia, the ratings agencies have chosen to turn cautious and to reverse their inherent tendency to talk up markets. Since emerging markets everywhere are fragile in a period of extreme volatility in international financial flows, they have now chosen to downgrade in advance rather than be caught napping by any sudden unpredicted collapse in investor confidence. So, even before completing a review of India's economic performance and the state of its finances, Moody's has declared that the intention behind the exercise is a ratings downgrade.

The problem, however, is that such actions or declarations are not themselves neutral in terms of their consequences. Ratings still do influence markets. Since investor confidence is all about expectations, a downgrade that spurs bearish expectations encourages existing investors to divest their holdings and potential investors to hold back. This is all the more true since rules written before disillusionment with ratings agencies set in bar certain institutional investors from investing in paper rated below investment grade. A cutback in potential investments and even a significant retrenchment of existing assets by Foreign Institutional Investors (FIIs) seems to be an inevitable fallout of the Moody's action.

FOR India's still partially controlled financial markets, this has two implications, one immediate and the other medium-term. The immediate fallout is likely to be a worsening of the incipient tendency for inflows of FIIs to turn negative. Since FII fund flows began in March 1993, November 1997 was the first month in which the net inflows were negative (to the tune of $149 million). The trend persisted in December, with an outflow of $182 million. These figures compare with the positive outflows of $114 and $102 million in the corresponding months of the previous year. At a time when India's exports are doing badly, the drain on India's foreign exchange reserves this trend involves could upset the Reserve Bank of India's (RBI) effort to manoeuvre a slow depreciation of the rupee. Given the collapse to the tune of 50 per cent or more of the currencies of India's East Asian competitors in international markets, the perception that the rupee in relative terms 'overvalued' has gained ground. This steps up exporter pressure on the Indian Government to ensure a depreciation. But it also sets up expectations of a likely depreciation, triggering speculative activity that threatens a steep slide in the rupee and a fall in foreign exchange reserves. In recent months, speculation of this kind has forced the RBI to outlay between $2 and $3 billion to protect the rupee. With foreign exchange reserves down to around $27 billion as a result, the threat of a speculative collapse in the rupee's value was real (see box).

It was because of this prospect that the Government has chosen to turn cautious on liberalisation, which increases the outflow of foreign exchange and the potential for speculative activity in currency markets. Inaugurating the Confederation of Indian Industry's (CII) "Partnership Summit" on January 9 in Chennai (see separate story), Prime Minister I.K. Gujral said that caution and prudence were necessary with regard to the opening up of the economy, particularly in the wake of the severe economic and financial crises in East Asia. The next day, at the same location, Finance Minister P. Chidambaram ruled out a "competitive devaluation" of the rupee as a response to the sharp depreciation of the currencies of India's East Asian competitors.

As is to be expected, these responses conflict with the assessment on the basis of which Moody's is threatening to downgrade India. While announcing its ratings review, Moody's declared that the move was driven essentially by the slowdown in the country's structural reforms owing to "a fragmented political framework and resistance by protected sectors". The official release by the managing director of Moody's sovereign-risk unit argued not only that "the impetus for structural reform has diminished relative to the agency's expectations when the country-ceiling ratings were raised to current levels in December 1994", but that "domestic political pressures are increasing that would further slow the pace of reform because of the volatility experienced recently in the more open Asian markets."

This conflict underlies the medium-term problem created by the Moody's review decision. It becomes a source of pressure on the Government to refrain from responding appropriately to the crisis in East Asia and to the recent signs of instability in the value of the rupee. In the brief time since he took over as the Governor of the RBI, Bimal Jalan has reversed some of the liberal policy decisions adopted by his predecessor with regard to liquidity creation as well as bank autonomy. The motivation for that retreat was the need to curb speculative activity by banks and corporates looking for quick returns from developments in the currency markets. That early reaction and the promise of greater control and supervision over currency transactions had made clear that all the hype about "capital-account convertibility", drummed up by the Finance Ministry and the previous RBI Governor, was to be downplayed and the policy shelved for the time being. In addition, a dose of caution with regard to import liberalisation, especially in the case of consumer goods, seemed inevitable to compensate for the tendency to net FII flows to turn negative.

THE Government's strength lies in the fact that the segment that the Moody's action affects directly, namely, the firms which plan to borrow from international markets, has shelved such plans in recent times. A series of monetary policy decisions and the slowdown in domestic economic activity have substantially increased liquidity in the system and eased domestic interest rates. On the other hand, the caution generated by events in East Asia has pushed up interest rates on foreign loans by as much as 100 basis points. In addition, since the servicing obligations attached to foreign loans are denominated in dollars, any depreciation of the rupee would increase the rupee cost of those loans substantially. For these reasons, firms are increasingly opting to borrow from domestic rather than international markets.

This implies that the principal impact of the Moody's decision will be on FII flows. Increased outflows would therefore be the main source of pressure on policy. Using the benefit of its still partially controlled financial markets, the easy liquidity conditions in domestic capital markets and the fact that the collapse in international oil prices has provided India with foreign exchange savings to the tune of $2 billion this financial year, the Indian Government can possibly weather the assault by international financial agents like Moody's and the interests they represent. This could be the attitude that drives policy in the near future. If this succeeds, India gains. If not, the course of events will be no different from that which results from meek submission to international pressure. Success will of course mean that India will discredit Moody's and other international financial interests in ways completely different from the beating they took in East Asia. Hence, resistance from the side of international finance could be intense.

Fortunately, the Government's task has been made a bit easier because, driven by domestic business interest, those who consciously or unwittingly serve as domestic supporters of international finance have had to change their tune. The likely outcome of these changed circumstances, however, still remains unpredictable.

More 'barriers' to come?

ON January 15, the value of the rupee fell below the market-created 'psychological barrier' of 40 to the dollar. Events since then suggest that the slide will continue. Liberalisation and the South East Asian 'contagion' have made it nearly impossible for the Reserve Bank of India (RBI) with its $27-billion foreign reserve to stop the descent immediately.

In the slide that is expected, the outcomes of two battles would decide where the rupee will settle. First, the battle between the interests of those who are predominantly exporters and those who are dependent on imports to sustain domestic production. While the latter experience a sharp increase in costs in the wake of the depreciation of the rupee, the former benefit inasmuch as the dollar value of Indian exports falls with depreciation, improving their competitiveness. Ramu Deora, president of the Federation of Indian Exporters, has said that despite the depreciation of the rupee since November from 35.68 to the dollar to 40.15 on January 15, "the rupee is overvalued" and that a further depreciation of at least 15 per cent was "needed". However, domestic producers whose dependence on imports has increased in the wake of liberalisation and are faced with sluggish demand conditions in the domestic market argue that any further depreciation will affect industrial growth adversely. Since exports do not provide the principal stimulus to industrial growth in India, the latter's argument does carry some weight.

However, this battle between those desperately striving to remain competitive in export and domestic markets respectively, is likely to be less of an influence on the movement of the rupee than the second factor. This is the battle between the RBI and those who resort to speculative transactions aimed at making gains from the depreciation of the rupee. Expecting a further fall in the value of the rupee, those holding dollars postpone inflows into the country and those having to make foreign exchange payments in the near future rush to purchase dollars as early as possible in order to reduce the losses they would suffer as a result of depreciation.

The demand for the dollar far exceeds its supply, and this raises its value. Speculators use this environment to hold dollars not just to hedge against risk but with the objective of pure financial gain. To counter this tendency the RBI has not only reduced access to liquidity for speculative purposes (such as the use of export credit to delay repatriation of export proceeds), but intervened periodically through the sale of dollars in the market to stall a steep fall in dollar availability and the rupee's value. The intention of the central bank is clear. It would like some degree of depreciation to keep exports competitive; but it would not like depreciation at a pace that increases the rupee costs of importers or the rupee repayment obligations of borrowers from international markets to an extent where closure or financial bankruptcy is a possibility.

There are two problems here. First, to ensure a gradual, rather than sudden, depreciation of the rupee, the RBI has already expendedin small doses around $3 billion from its foreign currency reserves. Its ability to sustain this process is, therefore, increasingly under strain, giving speculators the upper hand. Secondly, since November the rupee has depreciated by less than 15 per cent, whereas the depreciation in the South East Asian markets has varied between 35 and 65 per cent. So, if gradual but competitive depreciation is an objective of the RBI, events in South East Asia have made its task extremely difficult..

The process could go much further, This forecloses any definitive judgments on the level the rupee will finally find. The 40-to-the-dollar 'psychological barrier' may be just one in a series that the market may yet create and breach.