The deafening silence of Indian authorities has stood out in stark contrast to policy actions by other EM economies
The inexorable weakening of the rupee finally took it beyond 60 to a dollar last week. Many had thought that this was a line in the sand that RBI would defend. Alas, that wasn?t to be. And despite some pullback, the market is now staring at the prospect of the rupee drifting lower. To be fair, RBI has consistently reminded us that it does not target any exchange rate level. True to its words, RBI has only minimally intervened or so-to slow the pace of depreciation not to prevent it.
Since mid-May when fears of the US Fed tapering quantitative easing engulfed global financial markets, the vast majority of emerging market economies with current account deficit (Brazil, Indonesia, South Africa, Turkey, etc) experienced heavy bond outflow that have bled their currencies. However, in the last week or so, currencies in these economies have either stabilised or reversed direction. Not so in India. And before we go blaming the big bad foreign bond holders, let?s not forget that each of these other emerging market economies have substantially larger exposure to foreigners.
Similarly, initially rupee weakness was strongly correlated with worsening global sentiment. But in the past week or so global sentiment has improved. Not the rupee. This underscores the growing dominance of India-specific factors in rupee dynamics. Thus, the authorities? pleas that all this is unfortunate collateral damage of the global risk-off environment have begun to sound hollow.
Clearly, India?s large current account deficit is a key vulnerability. Consider the following. The June trade deficit is likely to have fallen to around $15 billion from the $20 billion shocker in May as gold imports fell sharply improving the current account deficit by roughly $5 billion. That?s an annualised run rate of $60 billion and about the same as last year?s. However, the straw that broke the camel?s back was the $5 billion debt and $2 billion equity outflows?the largest ever monthly outflow surpassing even the post-Lehman haemorrhage. An annualised run rate of $85 billion outflow! So it is not that unsurprising that the rupee sank like a stone.
But while the rupee weakness was triggered by the global asset sell-off, it is hard to argue that much of what followed wasn?t driven by self-fulfilling expectations of rupee weakness. Market fears and hopes have a nasty way of becoming self-propagating very quickly. If the market overwhelmingly believes that the rupee will depreciate, investors will pull out funds, which, in turn, will depreciate the currency and raise concerns that even a much smaller trade deficit will be difficult to finance, thereby rationalising the initial belief and propagating a vicious cycle of spiralling rupee weakness. Sounds familiar? Isn?t this what happened over the last two weeks or so?
But critical in this expectation formation was the belief that RBI would stay away until things got really bad. RBI has stayed away and things have gotten worse. At this stage, it is immaterial whether RBI considers the depreciation to be driven by fundamentals or not. By not defending the currency it has entrenched the market?s fear and greed, allowing rupee dynamics to be driven entirely by expectations.
When does the rupee stabilise? When this self-propagating cycle is broken. This can happen in two ways: either the market finally starts believing that the depreciation has been overdone or the authorities step in and draw a line in the sand. The first path is uncertain and could run long and deep. The second is quicker but will require strategic interventions, further liberalising controls on FDI and other capital inflows, and meaningful reforms before and during the upcoming monsoon session of Parliament.
The deafening silence of Indian authorities has stood out in stark contrast to the interventions and policy actions taken by similarly placed emerging market economies. That?s why their currencies have begun to reverse while the rupee languishes. Pick any central banking manual and it will state that the first line of defence in an exchange rate crisis is not intervening in the foreign exchange market but squeezing out domestic liquidity to sharply and, if needed, exorbitantly raise interest rates. Not policy rates but money market rates at which people borrow rupee, buy dollars, and then wait for the exchange rate to crumble. So far, RBI has made it ridiculously easy to do this: in June the monthly overnight interest rate was 0.5% and the depreciation 10%! During the two years of high inflation, RBI regularly reminded us of the importance of anchoring inflationary expectations. Inexplicably it doesn?t think that managing exchange rate expectations is important.
Some will argue that all this is just closing the barn door after the horse has bolted, that the rupee weakness is not all bad as it improves competitiveness, and one way or the other the rupee is finding some footing. First, there are still many more horses to bolt (about $250 billon in equity and debt). Second, while it is quite glib to argue that the depreciation will improve export competitiveness, the overwhelming empirical evidence shows that the price sensitivity of India?s export basket is statistically insignificant. So, yes, the depreciation will increase export profitability but will do little to raise demand or employment.
Lastly, this is the fourth time since 3Q11 that the rupee has gapped down. Each time the market hoped for a quick reversal. Each time the hope was dashed. Instead, every episode saw a new lower floor for the rupee being set only to be ratcheted down in the next sell-off. This time too the pattern is repeating. As before, hopes have been raised that the rupee sell-off will be reversed, instead the rupee is likely to settle to a new depreciated level without any line in the sand. And this serial ratcheting down, rather than improving competitiveness, will reignite inflation, substantially raise the budget?s subsidy bill, and stress corporate balance sheets.
The author is Senior Asia Economist, JP Morgan Chase. Views are personal