Self-fulfilling prophecies

Written by Neelkanth | Updated: Oct 8 2013, 08:20am hrs
With the rupee stabilising after a strong rebound, and a semblance of confidence having returned, it is time to look back and take stock of what really happened in July and August, when it seemed as if no level of the rupee was low enough.

The value of a currency is whatever everyone believes it should be. Over the medium term, economic forces do get currencies closer to where fair value should be, but unfortunately, there is no simple method to arrive at a universally agreed future fair value. This uncertainty is enough to drive cycles of greed and fear, exacerbated by expert economists who at the drop of a hat switch from growth differentials will make the rupee appreciate steadily to inflation differentials will make the rupee depreciate steadily. Policymakers trying to explain the fall inadvertently added fuel to the fire by justifying the currencys weakness through overly simplistic statements.

If you see a spark and cry fire in a crowded theatre, the chances are more people will get hurt in the stampede to escape than the fire. Experts who grimly predicted a steady depreciation of the rupee in public forums, acted no differently, though their self-image was probably more benign.

There is nothing wrong with discussing possible causes, but incorrectly justifying the fall publicly (and worse, giving sensationally pessimistic forecasts) spreads fear. Not surprisingly, the supply of dollars from exporters had dried up: they were holding up as much as they could. Importers on the other hand were effectively buying dollars for several years worth of imports. As excessive demand for the dollar forced the rupee down further, further waves of speculation were triggered. Contrary to the popular belief that evil hedge funds on foreign shores were big sellers of the rupee, almost US$13-15 billion of flows happened in July and August due to corporates panicking about the currency.

Any one-line explanation for the currencys continued weakness is like a quack over-simplifying a complex illness, and in the process hurting the patient. No less a person than Nobel-laureate Paul Krugman wrote in his book Peddling Prosperity that economics is a primitive sciencenot far from where medicine was a hundred years back. By then we had figured out how the human body works, but didnt know enough to cure diseases: life expectancy hadnt changed much for 2000 years. Then something clicked, and cures started coming through: life expectancy surged. That such definite ideas dont yet exist in economics makes it susceptible to over-simplification and politicisation.

Lets start with the most commonly used argument to explain the rupees weakness: the Current Account Deficit (CAD), i.e. we import more goods and services than we export. The CAD was indeed scarily high last year. However, with the Indian economy slowing rapidly (bringing down imports), the global economy recovering (helping exports), as well as the curbs on gold imports, the CAD had already shrunk dramatically by July, and yet the rupee kept falling.

Then lets take this propensity to link the rupees fall to that of other Emerging Market (EM) currencies. The link indeed exists, but since May 22, when EM currencies started to fall, the rupee was the weakest by far. Moreover, as Credit Suisse research shows, currencies of several countries with comparable CADs to Indias did not fare as badly. Most importantly, Indias CAD was shrinking in July and August while that of other EMs was expanding.

The third argumenthigh inflation is driving currency weaknessis not completely incorrect but only half true. It is simple logic: higher inflation in India drives up manufacturing costs and makes exports less competitive and imports more so, expanding the CAD. It would seem the rupee should keep falling till inflation is high. But economic theory also says only inflation in tradeable goods matters: if the price of food, hair-cutting or a taxi ride goes up for example, it does not directly affect the trade in goods and services. After all, one cannot go to the US to take a taxi ride from Bandra to Nariman Point, or go to Shanghai for a hair-cut. Core manufacturing inflation, which directly impacts the trade balance, has already fallen meaningfully in India, making this a weak argument.

We have come full circle. Only three years back, the fad was to project a steady appreciation of the rupee based on growth differentials, i.e. because India was likely to have higher growth than elsewhere (which is still true, despite the fall in growth rates in India), more capital would flow into India.

This selective theorising drives needless volatility, and causes much damage in its wake.

Unfortunately for the rupee, no one seems to have faith in it. The common man, conditioned by decades of rising gold price in rupee terms, consistently shorts the rupee by buying gold. Corporate India is susceptible after a series of disappointments: when they hear the rupee may fall, they believe it. And lastly, and most unfortunately, the very policymakers who profess to reduce volatility didnt seem to have faith in it, at least in their actions.

It is not hard to understand why the government didnt seem to be too worried: the rupees fall has low impact on the consumption basket of rural India, i.e. the common man. But this is a myopic approach, and ignores the cataclysmic consequences of an uncontrolled run on the currency. A run on the currency is no different from a run on a bank: it can very quickly go out of control even if not fundamentally warranted. These runs are driven by mass hysteria, and just like a mob may do what individuals in the mob may never have done by themselves, it can cause significant damage to the economy.

Currency volatility is like high inflation: it disrupts business activity by impairing pricing mechanisms. After all, small exporters and importers should not need to hire experts to get a view on the currency, or be forced to book losses when they act out of fear. While a currency must find its own level, policymakers must reduce volatility, giving time for the real economy to adjust to a new level. For now, the risk is of rupee appreciation: slowing it down should be easier.

The author is the India Equity Strategist for Credit Suisse