Currency wars? is the motif du jour of global finance. As with real thing, even an accurate precision strike will result in collateral damage. In this case, it might be India.
That prospects of additional Quantitative Easing by major central banks in developed countries has coincided with a renewed surge in the equities markets of emerging countries is certainly not a coincidence. QE, hitherto, has not had much of an effect in increasing bank lending in developed markets, but has now morphed into a potent tool for engineering currency depreciation. Japan learnt the lesson very quickly. A brief period of active currency intervention by the Bank of Japan yielded very little, forcing the central bank to drive its policy rate down to zero and announcing a 5-trillion yen securities purchase programme. The recent slide in the dollar started with the Fed?s FOMC statement indicating a renewed QE programme. Prospects of continuing and even increasing QE, in turn, will further spur carry trades, which have been potent for most of the year.
As global Treasury chiefs and central bankers gather for the Fund-Bank meeting in Washington, DC, the fears of the effects of a developed world awash with liquidity and red fiscal ink boiling over into emerging markets have begun to assume frenzied proportions. Japan, Brazil, Peru, Taiwan, Korea, have all intervened to weaken their currencies. Brazil, one of the largest destinations of foreign portfolio funds, in addition, increased its IOF (Financial Operations) Tax on foreign inflows into fixed income and investment funds from 2% to 4%. Countries have also begun to demonstrate that they are willing to live with higher inflation than they might think optimal, forgoing monetary tightening and living with the tradeoff of lower interest rates not giving an additional incentive for foreign funds to seek arbitrage returns.
While most emerging markets have responded quite sensibly to the capital inflows, the challenge for policy authorities there is to prevent asset bubbles from building up.
Policy authorities in India must be getting increasingly worried about the prospects of a surge in foreign funds flows into India, even more than in 2007 and early 2008, and memories of the consequences of domestic liquidity management remain fresh. The rupee has appreciated 6% against the dollar over the past month, about the same as some other large EMs, but much more than Brazil?s 3%. In this context, the following are some thoughts, loosely woven together on India?s external links.
One, the criticism of the recent increase in caps on foreign portfolio investment in Indian sovereign and corporate debt is largely misplaced. India needs to tap into global capital pools to fund the massive investments that are required, particularly for infrastructure, at which the limit relaxations are targeted. Global funds can be accessed in two ways. Indian borrowers raise foreign currency resources abroad (external commercial borrowings), increasing our external debt, or foreign investors provide funds in local rupee currency (portfolio investments). In the event of economic stress, the former can result in foreign currency defaults, even under conditions of basic domestic solvency, whereas the chances of an outright default is probably lower for rupee-denominated debt. Both events would entail a sharp depreciation of the rupee, but in a Pareto sense, the latter is a preferred option.
Second, in India?s case, the effects of capital flows driven appreciation of the rupee in an environment of a large current account deficit are particularly worrying. Normally, a widening current account deficit should set in motion an equilibrating mechanism, with a depreciating currency expected to boost exports with increasing competitiveness and the rising cost of imports reducing the demand for goods sourced abroad and diverting this to domestic manufacturers. This ?automatic stabiliser? shrinks the gap. A gush of capital flows distorts these demand and supply signals and encourages a sustained widening. This would not be a problem in itself, except that beyond a threshold, this creates investor risk aversion, leading to a sudden reversal of capital flows and very large movements in currencies, which tends to be disruptive for macro stability.
So what might be a sensible menu of options for India? Overall, leaning against the wind by RBI is not likely to make a material difference to the direction of the rupee for any sustained period of time. However, India needs to increase its exports to counter the inevitable inflow of foreign funds. India does not diversify its demand markets, but, this somewhat paradoxically, might actually provide greater leverage to act against continuing capital flows. A multi-pronged strategy is needed to boost exports. In the short time, I am veering around to the view that a weak currency might be the primary driver to achieve this, with the absorption of the attendant costs. However, this can help only for very limited periods, even as the basic economic fundamentals of export infrastructure get strengthened.
?The author is senior vice-president, business & economic research, Axis Bank. These are his personal views