On June 28, 2018, the Indian rupee plunged to an all-time low of 69.10 against the US dollar amid growing concerns over tightening of global financial conditions and higher crude oil prices coupled with the worsening of domestic macroeconomic variables, especially the current account balance and inflation.
The mad rush for dollar by importers and currency speculators was halted temporarily after the central bank, RBI, aggressively intervened in the currency markets by selling dollars in both spot and forward markets to arrest the slide in the rupee.
If the RBI had not intervened in the currency markets on that day, the rupee might have breached the psychologically crucial mark of 70 to a dollar.
The RBI has not yet disclosed how much foreign exchange reserves were spent on that day, but market observers estimate that the RBI might have spent close to $2 billion in the forex markets to stem the fall in rupee value.
After a gap of four years, the RBI increased the benchmark repo rate, the rate at which the central bank lends money to banks, by 25 basis points on June 6, citing upside pressure on inflation due to rising crude oil prices which hit $80 a barrel in mid-May 2018. However, this move has not stopped the rupee from falling.
Analysts predict a weaker rupee in the coming months. It is expected to remain in the 68-72 range against the US dollar during the year amid high oil prices, tightening of global liquidity, a strong dollar and growing protectionist tendencies.
Analysts also predict one more policy rate hike by the RBI in the range of 25-50 basis points before the end of 2018.
Dwindling forex reserves
Due to capital outflows and intervention by the RBI in the currency markets, India’s forex reserves have fallen in recent weeks. As per latest RBI statistics, forex reserves declined $6 billion (from $413 billion to $407 billion) within a period of two weeks (June 8-22, 2018).
The current levels of India’s forex reserves can cover ten months of imports but what should be worrisome is that the magnitude of volatile capital flows (consisting of portfolio inflows and short-term debt) to forex reserves. The volatile capital flows constitute close to 86% of forex reserves. Such short-term private capital flows are prone to sudden reversals while their positive contribution to the economic development of the host country is very limited. More importantly, volatile capital flows have the potential to perpetuate a currency crisis in emerging markets, as witnessed during the Asian financial crisis of 1997.
India is currently caught in a classic ‘impossible trinity’ ‒ the policy trilemma ‒ which implies that a country cannot achieve free capital mobility, a fixed exchange rate and an independent monetary policy simultaneously.
‘Taper tantrum: part II’?
It is worth recalling here that similar aggressive interventions by the RBI in the currency markets was seen in 2013 when the rupee went into a tailspin following the ‘taper tantrum’ episode – a mere hint by the then US Federal Reserve Chairman Ben Bernanke that the Fed may phase out its asset purchase programme (commonly referred to as quantitative easing).
That announcement caused panic selling in bond and equity markets all over the world. In particular, EMEs with higher current account deficits, high inflation and low forex reserves witnessed sharp market volatility followed by drastic exchange rate depreciation and capital reversals. The impact was felt acutely by those EMEs which received substantial capital inflows from advanced economies during the QE programmes.
The ‘taper tantrum’ episode also had an adverse impact on the Indian financial markets, which experienced large swings in asset prices. The foreign institutional investors (FIIs) pulled out money from the Indian debt and equity markets while panic-stricken importers rushed to buy dollars to honour their payment commitments to overseas sellers. The large capital outflows and increased demand for dollars resulted in sharp rupee depreciation. The rupee depreciated by over 20% during the tapering episode.
In 2013, five EMEs ‒ India, Turkey, South Africa, Indonesia, and Brazil ‒ were described as ‘fragile five’ (a term coined by a research analyst at Morgan Stanley) that were facing similar financial risks due to the threat from the reversal of QE programme.
To avert a potential financial crisis in 2013, the RBI deployed a wide range of policy measures to safeguard financial stability. These included monetary tightening via the cash reserve ratio (CRR) and the liquidity adjustment facility (LAF); imposing restrictions on import of gold; special window for swapping foreign currency deposits; banning banks from carrying proprietary trading in currency derivatives; tightening the position limits on currency futures; prohibiting arbitrage trades between futures and OTC markets; and imposing new restrictions on capital outflows by resident Indians.
Some analysts argue that the Indian economy is nowadays better placed to deal with global financial shocks than it was in 2013. There is no denying that macroeconomic variables such as real interest rates, current account balance, fiscal balance and forex reserves are in better shape than the ‘taper tantrum’ episode of 2013, but one cannot overlook the simple fact that this time the threat of monetary tightening is real as the US Fed and other central banks of advanced economies have already started phasing out their QE programmes.
The European Central Bank has recently announced that it will phase out the quantitative easing programme by the end of 2018 while the pace of asset purchases by the Bank of Japan has slowed down sharply in 2018. In the US and the UK, the benchmark interest rates have been raised.
Spillovers from US monetary policy ‘normalisation’
India needs to stay extra vigilant as new financial risks emanate from the ‘normalisation’ of monetary policies in the US and other advanced economies. Since India’s financial markets are far more interconnected globally than a decade ago, tightening of monetary policy in the US and other advanced economies could prove disruptive, leading to “sudden stop” or reversals in capital inflows.
The spillover effects of global financial market volatility to India (and other EMEs) are expected to be severe in the coming months as the US Federal Reserve has already started tightening its monetary stance. Between March and June 2018, the Fed has raised its benchmark short-term interest rate twice. Two more hikes are expected by the end of the year as the Fed is keen to speed up its monetary policy ‘normalisation’. Higher interest rates would encourage American investors to pull out their money from emerging markets like India and invest in the US markets.
In addition to the unwinding of the Fed’s balance sheet which sucks dollar liquidity from global financial markets, there has been an increased issuance of US Treasury bills this year to finance the federal budget deficit that is widening as a result of the Trump administration’s $1.5 trillion tax cut. This move would further squeeze the pool of dollars floating outside the US.
There are clear signs of increased outflows from EMEs due to the tightness in US dollar liquidity. According to the Institute of International Finance, foreign investors pulled out a net $12.3 billion out from emerging markets in May 2018. Out of which, nearly $8 billion was pulled from Asia alone.
In the case of India, FIIs pulled out a massive Rs 478 billion ($7 billion) from the Indian financial markets during the first half of 2018 – the steepest outflow not even seen during the global financial crisis of 2008. The capital outflows were largely concentrated in the Indian debt markets, accounting for nearly 86% of the total outflows. In the equities segment, exchange-traded funds (ETFs) witnessed higher outflows.
The further tightening of financial conditions will have serious repercussions for India’s balance of payments. A rise in India’s trade deficit due to higher crude oil prices is bound to further widen the country’s current account deficit. India and other EMEs with large current account deficits are particularly vulnerable to “sudden stops” and reversals in capital flows.
If large and sustained capital outflows persist for the rest of the year, India’s forex reserves would be inadequate.
Rupee depreciation and its consequences
A weak rupee would make imports of goods and services costlier. The firms will pass on increased import costs to the end-consumers.
A depreciating rupee along with higher oil prices would prove to be a double whammy for the Indian economy. India is the world’s third-biggest oil consuming nation after the US and China. At present, India imports about 82% of its crude oil consumption. Notwithstanding official pronouncements, little efforts have been made in the past two decades to reduce dependence on oil imports by boosting domestic oil exploration and production. As a result, the country’s dependence on oil imports is increasing by the day. Crude oil is the largest import bill for India.
Since April 2018, international crude oil prices have surged in response to production cuts undertaken by OPEC, the rise in geopolitical tensions in Asia and economic sanctions imposed on Iran by the US. With Brent crude oil prices currently hovering around $74 a barrel, it will worsen India’s current account deficit besides stoking high inflation. In addition, the country’s fuel subsidy bill will increase, thereby adding to fiscal pressures and forcing the government to curtail social sector spending. If the government asks state-owned oil firms to share the fuel subsidy burden, it will directly affect the profitability of these firms.
The rupee depreciation should also cause worry to India Inc. due to their unhedged currency exposure. Although the exact data on the use of hedging against currency risks by Indian corporates is not available, a study by India Ratings found that only 36% of the top 100 corporations with overseas borrowings are hedged for currency risks.
Taking advantage of ultra-low interest rates prevailing in the advanced economies in the post-crisis period, non-financial corporations from India (and other EMEs) issued foreign-currency debt (mostly in the US dollar) in international markets. The external commercial borrowings (ECBs) of Indian corporates have significantly increased during the post-crisis period.
The rupee depreciation will directly affect the balance-sheets and credit profiles of such corporates that have issued securities without proper hedging currency risks. These corporations may find it difficult to service their foreign-currency debt and may suffer huge losses due to increase in repayment burden.
Will a weaker rupee boost exports?
There are some who argue that a weak rupee will make exports more competitive and thereby spur exports of goods and services. A weaker currency alone cannot boost a country’s export while a gradual, non-disruptive depreciation as part of a wider trade strategy can be beneficial in the long run.
In the current context, a depreciated rupee may not help much in boosting exports due to four key reasons.
First, the ongoing currency depreciation is not unique to India. The currencies of many other EMEs are also depreciating concurrently. Some competing EMEs have witnessed even greater depreciation in their currencies. Besides, their exports basket is not vastly different from India’s. In such a scenario, the ongoing rupee depreciation is unlikely to boost India’s exports.
Second, the recent episodes of rupee depreciation had no significant positive impact on Indian exports. During the ‘taper tantrum’ episode of 2013, Indian rupee lost 20% of its value, but that did not result in higher exports.
Third, a large segment of India’s merchandise exports (such as gems and jewellery, chemicals and textiles) has a very high import intensity due to their dependence on imported inputs. For such export items, any gains from a depreciated rupee will be automatically neutralised by higher costs of imported inputs.
Fourth, it is not easy to stimulate exports when the global demand is sluggish. As global demand is expected to remain subdued in the next few years, India’s export prospects are limited. Besides, protectionist tendencies are on the rise around the world. Despite having a competitive advantage in IT services, India’s IT services exports are facing headwinds due to the rising tide of protectionism in key markets. At a time when the world’s two biggest economies are headed for a trade war, the outlook of India’s exports remains gloomy.
Time for a more cautious approach
Though the finance minister has recently stated that the government will not have any “knee-jerk reaction” to stem the rupee fall, the Indian authorities need to remain cautious as any market or political turmoil in large economies can potentially trigger global risk-off sentiments. In such circumstances, the Indian financial system and the real economy cannot remain immune to global meltdown.
Financial market volatility is here to stay as advanced economies are unwinding years of loose monetary policies. The growing trade tensions between the US and China could severely undermine the multilateral trading system. These global developments will continue to exert downward pressure on the rupee in the coming months. It is therefore imperative for Indian policymakers to prepare for all eventualities and to develop a robust policy framework which provides sufficient policy space when responding to external shocks.
There is a need for developing an appropriate monitoring system to detect where financial vulnerabilities are building up. The regulatory authorities should not hesitate to use capital controls, macro-prudential and other measures in a proactive manner to safeguard macroeconomic stability.
From a development perspective, the quality of capital flows is important. The policy emphasis should be on attracting long-term capital inflows that improve productive capacity rather than short-term, volatile flows that are prone to abrupt reversals.
The need for international cooperation
Needless to add, India should improve its macroeconomic fundamentals. In addition to keeping one’s house in order, India should actively engage and lead discussions on addressing the shortcomings of current international monetary and financial arrangements through international cooperation. The current scenario demands international policy coordination to safeguard global financial stability.
International policy coordination can occur at various fora including G20. Being a founding member of the G20, India should put these issues on this forum’s policy agenda. India can enlist support from other G20 member-countries – especially Argentina, Turkey, Brazil and Indonesia – that are currently facing similar financial risks. The upcoming meeting of G20 finance ministers and central bank governors later this month in Buenos Aires offers an opportunity that should not be missed by New Delhi.
Kavaljit Singh works with Madhyam, New Delhi.