On the leeward side

Written by Neelkanth | Updated: Feb 4 2014, 18:24pm hrs
Several emerging markets (EMs) are in crisis mode again. Argentina and Venezuela have been forced to devalue their currencies, the Turkish lira has depreciated against the US dollar, and so has the South African rand.

The rupee, on the other hand, is holding up relatively well so far. Recall the three tempestuous months for the rupee, from June to August last year This was due to rising expectations of the United States Federal Reserve tapering its monthly purchase of bonds (the taper). India was one of the Fragile Five (Brazil, Indonesia, India, Turkey and South Africa): economies whose currencies were expected to weaken significantly when the taper eventually started.

This was attributed not just to their high current account deficits and dependence on foreign capital, but also because all of these economies are facing political uncertainty: all five are headed for elections this year. For India, most market commentators were talking of a recurrence of the currency crisis of 1991.

The taper started in December and, indeed, in the last three months, four of the Fragile Five currencies are down 10 to 15 per cent against the US dollar. The market capitalisation in US dollars for Brazil and Turkey are back to the lows seen in July-August last year. Even markets in South Africa and Indonesia have fallen close to their lows. However, the fifth, the Indian rupee, is down a mere 3 per cent, and total market capitalisation of the Indian markets is almost 30 per cent higher than the lows seen in August last year. The sense of crisis prevalent in markets like Argentina, Turkey and Brazil is therefore absent in India.

What has made India stand out thus far among emerging markets, and can the rupee and the economy withstand the current turmoil in the global economy Of several possible reasons, there are only two that matter in my view: the first, a sharp decline in the current account deficit, and the second, the remarkable $34 billion that flowed in through the measures taken by the RBI towards attracting NRI deposits and banking capital. Both demonstrate the core strengths of India, despite all the negative publicity around unhappy corporations, noisy democracy and governments which act only with their backs against the wall.

Indias trade deficit has shrunk dramatically over last year, and by far the most among all emerging markets. From a monthly run rate of close to $17 billion in the run-up to the crisis period last year, it has been averaging about 10 billion a month. Of this $7 billion fall in the monthly rate, only about $3 billion is due to the decline in gold imports, and the rest due to other factors. While a large part of the decline in gold imports is indeed due to the quantitative restrictions placed by regulators (considered non-fundamental by many), a meaningful part of the decline in gold imports is also due to lower gold prices. They are down from an average of $1660 an ounce in the last financial year to about $1250 an ounce currently, a 25 per cent decline.

The larger part of the decline in the trade deficit is instead coming from a rise in exports and a fall in (non-gold) imports, as the weak currency and rising domestic surpluses have allowed Indian manufacturers and farmers to gain competitiveness (The upside of the falling rupee, IE, October 4, 2013, goo.gl/Zfgm3u). Farmers in particular have been the strongest beneficiaries of the weak currency, as they have the largest proportion of their costs in rupees. Weakness in the domestic economy is also doing its bit for the decline in imports, as demand for items like capital goods and steel scrap has come down sharply, and that for crude oil is not growing.

But any amount of fundamental improvement cannot prevent speculative moves on the currency. Near-term movements in pricing are almost always driven by sentiment. This is where the three-year deposits that flowed into India from NRIs till November come in: they reduced the liquidity risk for the currency. The difference between solvency risk and liquidity risk needs some explanation. While the economys dollar liabilities have risen sharply in the last decade, as a percentage of domestic output they are still low. This means solvency risk is low.

However, the liquidity risk was high: a large part of the debt is short-term in nature, implying that if all these lenders were to ask for their dollars back at the same time, India would be in a spot of bother. Liquidity risk can sometimes drive solvency risk, as at the time of greatest need, even longer duration dollar debt becomes unavailable.

The deposit scheme encouraged and supported by the RBI brought in $34 billion, close to a full years current account deficit (as per the current run rate), and thus helped reduce the liquidity risk for the economy, strengthening the currencys position against speculative attacks.

The coming weeks are likely to be turbulent, with some uncertainty from the crisis-like situations in many emerging markets, a narrowly averted default in China of a wealth management product and a temporary slowdown in global output growth. India is likely to be buffeted by the turbulence elsewhere. After all, Indias global linkages have increased significantly in the last two decades, from the perspective of trade as well as capital flows. Redemption pressure on broader EM funds, for example, could cause capital outflows from India, pressuring domestic markets, even if only temporarily. Or, commodity producers in India could be hurt by falling prices as global growth gets affected by the uncertainty. Sentiment about India may also be affected by changing forecasts of the electoral prospects of various parties in the upcoming general elections.

However, short of a full-blown default somewhere in the EM universe, which can create systemic stress in the global economy, in our view a crisis in India is unlikely. Thus far, a pattern has emerged that the currencies and stock markets of EMs that have seen declines in their trade deficits have held up, and those that havent improved or deteriorated are under stress. Indias improved trade balance and steady medium-term growth prospects should ward off calamitous developments.

The writer is the India Equity Strategist for Credit Suisse