The situation then was eerily similar to what we see now: the economy was suffering from the after-effects of badly planned unviable investments, and inflation had come off, encouraging RBI to ease monetarily. But then some emerging markets (EMs), particularly the South-East Asian economies, after several years of dramatic growth, descended into crises. With Indian domestic demand resilient, and exports falling due to slowing global growth, the current account deficit (CAD) increased sharply at about the time that fund flows dried up. In the month of November 1997, the rupee fell 9%.
In response, RBI applied some band-aid in December by tweaking the norms of export and import financing. But as the crisis spread in Asia, the rupee fell another 4% in the first 15 days of January 1998. Out came the bazooka: a 200 bps hike in the bank rate (the policy rate at that time) to 11% on January 16, 1998. Once the rupee had stabilised at 39-40 levels against the dollar, by March RBI started to reverse this trend, and by end of April the bank rate was back to 9%. Rates continued to fall for the next three years.
What was remarkable was the environment in which this reversal happened, and there lies the lessons for us. FII flows as well as short-term debt remained negative for another two quarters (likely affected by the sanctions imposed post the Pokhran tests in May 1998), and trade deficit only started to fall from July 1998. So why then did RBI reverse its earlier decision
It did so because its goal had been achieved: exchange rate stability for three months. While a weaker currency can itself drive a normalisation of the balance of payments, the economy needs time to adjust to a new exchange rate. A weaker currency helps export growth only with a lag of 3-4 quarters. Even for imports, which become more expensive as the currency falls, the impact is felt only after at least 2-3 months. Importers need to re-price their fare before consumers start finding them more expensive. For important imports like oil, the price transmission can take much longer.
The challenge though is that capital markets move much faster than the real economy, and sometimes a falling currency can itself drive more weakness, akin to the run on a bank. Left to its own means the rupee could have plunged lower, somewhat like a stock where the fair value could be 100, but for a few weeks if not months can stay much higher or lower than 100.
This exchange rate stability is exactly what RBI desires right now: in our view it does not, and cannot have a view on the eventual level. The rupee is down by more than 10% against the dollar since the middle of May this year, and on a 36-country Real Effective Exchange Rate (REER), it is the cheapest it has been in two decades. This implies demand destruction in the domestic economy caused by the weaker rupee, as well as the opening of new export opportunities should help stabilise the rupee at current if not higher levels.
So, can we now start planning for RBI reversing its recent decisions by October, three months from now If the rupee stays stable, it most likely will. But one needs to stay cautious.
After all, tempting as the similarities may be between now and 1997-98, there are meaningful differences. For one, the Indian economy is much more integrated to the world than it used to beboth in terms of a much higher than earlier CAD, as well as the concomitant capital flows. The recent opening up of the capital account by increasing limits for FII debt investors has so far turned out to be horribly ill-timed. But there is a silver lining if one may call it. The stampeding out of FII debt investors has allowed a forewarning of a potential crisis globally. At present, none of the EMs has a crisis yet, but one cannot be ruled out.
Such a development would prolong the pressure on the rupee, and therefore the tightening measures by RBI. The liquidity risk to India is particularly high given the dangerously high reliance on short-term debt in the past year to finance the CAD. Short-term debt with residual maturity (i.e. the foreign currency debt that needs to be refinanced in the next 12 months) is now almost two-thirds of Indias currency reserves. A prolonged crisis globally can therefore pose a serious threat to the country.
But such a scenario has low probability, and the likelihood of a prolonged period of high interest rates is rather low.
The author is Credit Suisses India Equity Strategist, based in Mumbai