In a contagion, no one can escape the flu; but the virility of the infection depends on one?s immunity
Indian policymakers must be wondering what it takes to restore a sense of macroeconomic stability for any length of time in this economy! To their credit, they acted swift and decisively last September and, along with a central bank that held its nerve, finally began to experience tangible results a month ago. WPI inflation fell to a three-year low, CPI inflation finally began to abate and we found out that the fiscal deficit fell all the way to 4.9% of GDP. A palpable sense of stability was finally returning.
But the calm simply turned out to be the lull before the storm. Ben Bernanke winced, financial markets sneezed, and emerging markets caught the flu. The Indian rupee has been falling like a stone over the last three trading sessions, has closed at new record lows each day this week and is currently 3% lower than just a week ago and a whopping 8% lower than a month ago.
So how does one make sense of all this? There are several issues at hand and they need to be disentangled. What has driven the rupee?s violent move? How much of this is dollar strength vis-?-vis India-specific vulnerabilities? Can things get worse before they get better? What are the macroeconomic implications of the recent move? And, most daunting of all, what is the rupee?s fair value?
For all of India?s vulnerabilities, the genesis of rupee weakness over the last month is not of our own making. Stronger-than-expected US data over the last few months and an improving labour market has meant that there is a growing possibility that the Federal Reserve will start tapering its asset purchase programme in September. US treasury yields have predictably risen but, in so doing, caused a massive repricing of fixed income assets in emerging markets across the world. Consequently, these currencies have bled on large bond outflows. Much of the rupee weakening over the last month is, therefore, simply an upshot of this generalised dollar strength and repricing of risk assets. As a sidebar, so much for rational, forward-looking markets and efficient pricing of risk! A Fed exit was always on the cards in 2013, and one would have thought that the likelihood of that was ?in the price?. The evidence of the last 10 days clearly suggests it wasn?t. We are experiencing the beginning of the end of easy money, and financial markets?living on steroids?will take some time to cope with the new reality.
But even as the move may have been precipitated by global factors, the quantum of the rupee depreciation over the last month?and even last few days?is by no means accidental. In the current mayhem, the large current account deficit (CAD) countries such as South Africa, India, Brazil, Mexico and Chile have experienced the most bleeding. And that is something that we have been shouting from every roof-top for the last few months. India?s biggest vulnerability is an unsustainably high CAD that is increasingly financed by risk-on, risk-off portfolio flows and trade credits. As such, at the first signs of global stress, the rupee feels the pain (remember August 2011? December 2011? May 2012?). Some months ago there was misplaced optimism that our CAD problems were over when gold and oil prices fell. But as I pointed out on these pages our CAD problems extend beyond commodities?coal, fertiliser, scrap metals imports have surged and iron ore exports have plummeted on regulatory and policy uncertainty at home. Much of the correction of the CAD lies in our own hands. And, so long as the CAD remains bloated and FDI relatively muted, India remains exposed to the whims of global financial markets.
But fundamental factors apart, the rupee has continued to weaken sharply over the last two trading sessions even as a trace of sanity is returning to other large EMs. Why is that? As so often happens, currencies overshoot and expectations get unhinged. And this is where perhaps our central bank has missed a trick. We finally saw some intervention late last afternoon. But with RBI staying on the sidelines, the rupee was falling like a stone underpinned by self-fulfilling prophecy. Market participants were convinced the rupee was headed weaker. Therefore, exporters held back, oil companies front-loaded demand and the currency did indeed weaken. Determining the quantum and timing of FX intervention is never easy. It?s an art more than a science?but perhaps RBI could have acted sooner to anchor expectations.
Why does all this matter? Because an 8% depreciation in a month can be terribly destabilising. This is likely to fuel imported inflation, put pressure on unhedged corporate balance sheets, and significantly increase oil under-recoveries. A June rate cut is already off the table (a central bank cannot be seen to be cutting rates?the opportunity cost of shorting the currency?when the currency is under such severe pressure) and if things don?t settle down soon, a July cut will also be imperiled. A beleaguered corporate sector will have to live with higher interest rates, and more stressed balance sheets from a weaker rupee?never a good cocktail to jumpstart investment.
So where to from here? Depends on your time horizon. Decisive intervention from RBI could stem the tide in the coming week. But more challenges lie ahead. RBI?s mid-quarter review is likely to be characterised by relatively hawkish language, something that could displease equity markets. Plus, Monday?s FOMC meeting is all-important. Relatively hawkish language from the Fed could again set the cat among the pigeons in some EMs.
If we can get through this tricky phase, though, there could be some fundamental and technical relief. Gold imports have predictably begun to fall-off sharply and investors who were very long on the rupee in May (it was the most favoured currency in Asia !) have cut these long positions.
But even as the near-term value of the currency will be dictated by these push-and-pull factors, its longer-term fundamental value will still be determined by India?s growth and productivity differential versus its inflation differential vis-?-vis our trading partners. Ultimately, it?s growth and productivity differentials that drive the equilibrium real exchange rate. And, given that, the inflation differential drives the equilibrium nominal exchange rate. So, what does this suggest for India? With India?s growth differential narrowing significantly and inflation differentials?while narrowing?still high, a modest, orderly depreciation of the currency (and one that helps reduce external imbalances) is not inconsistent with the fundamentals. No one is suggesting that current levels reflect any sort of equilibrium. But once things mean-revert, as long as inflation differentials are high and India?s growth differential with the world stays relatively narrow?an orderly depreciation of the currency is both warranted and desirable.
For now, the emerging market world remains in fire-fighting mode. But the lessons from the last 10 days should be clear. In a contagion, no one can escape the flu. But the virility of the infection depends on one?s own immunity.
The author is India economist, JP Morgan