Financial instruments were the most important question of 2008. Currencies could well get that ?honour? in 2009. And the two most important questions for India, of course, are: what will happen to the US dollar, and what will happen to the Indian rupee. The dollar presents a paradox. The US was the epicentre of the crisis. Yet, massive capital flows came to the US in the aftermath of the crisis, driving up the dollar to unprecedented levels. These were related to a ?flight to quality?. Investors worldwide were uncomfortable with holding credit risk and chose to buy US government bonds, driving down the interest rate on the 90-day treasury bill in the US to zero. In 2009, that flight to quality is likely to subside. Already, there are many signs of stabilisation in the financial system. The VIX, which measures the uncertainty of the S&P 500 index, has dropped by almost half to levels which would be considered high but not unbelievable in 2007. The 90-day Libor has dropped to 140, reflecting greater comfort on the part of the financial firms about each other. Interest rates in the US have dropped dramatically. Investors are itching to get out of US government bond investments. Once the panicked flight to quality is out of the picture, will money leave the US? While this is likely, it is important to keep the gloomy picture for the rest of OECD in mind. In continental Europe, Japan and the UK also, growth prospects are gloomy. In dollar terms, these countries would have normally absorbed very large investments; the paucity of investment opportunities there thus leaves spare capital in the world economy.
The US (and the UK) has a big edge when compared with continental Europe in supporting entrepreneurship, immigration, a hire-and-fire culture on the labour market and thus the rapidity with which the downturn will be absorbed. The only sparks of optimism, other than the US, are some emerging markets like China and India. But in dollar terms, these cannot absorb large amounts of capital. Hence, there is a good possibility that even after the financial panic has subsided, the strength of the dollar may continue, owing to weaknesses in other OECD countries. As a side effect, the strong dollar adversely affects the ability of American firms to export to the rest of the world, and complicates the recovery in the US.
Turning to India, there are reasons for optimism about the rupee for two reasons: capital flows and commodity prices. In the public imagination, capital flows have ?collapsed?. But a closer look at the data shows that this is not the case. The FII outflow of 2008 was only $13 billion or 1.3% of GDP. The word ?sudden stop? is being loosely used about capital flows to describe India?s experience in 2008, but this is not what the data shows. Looking into 2009, the world is a gloomy place for institutional investors worldwide. Europe, Japan, the UK and the US are all doing badly. They offer poor prospects for investment. Of the BRIC countries, Russia has betrayed institutional fragility and a reliance on oil revenues. Brazil has also suffered badly with the drop in commodity prices (while showing surprising institutional capability, owing to the macroeconomic reforms of the last decade). China and India stand out as countries where there are good long-term returns on investment. This is the deep driver which is likely to yield positive surprises for capital flows in 2009.
The crash in commodity prices is a windfall for India that has not been adequately noticed. With imports of 2 million barrels a day of crude oil, we save $70 billion a year on reduced costs of crude oil imports alone. The story is not just in oil alone: many other commodity prices have also dropped. India has a massive task of building infrastructure, and lower prices of steel, copper, aluminum, telecom hardware, machinery, etc. are a godsend. As an example, the 3G rollout in India in 2009 will get done at a much lower price when compared with what would have happened in 2007 and 2008. Roads, railways, ports, airports?all these will be substantially cheaper. This is good news for India. Global imports will be weak in 2009, reflecting business cycle conditions. The rupee has weakened against the dollar, thus helping exporters. Indian firms have considerable headroom with unprecedented profitability and high wages in order to be able to compete in the world market.
From a currency perspective, a small weakening of the dollar might be a reasonable forecast for 2009. Putting this together with a modest increase in capital flows compared with 2008 and a sharp decline in commodity import payments, the outlook for the rupee for 2009 appears to be positive. This is, of course, assuming that RBI allows the price to be determined by the market. If there is a reversion to administered prices, then other outcomes might come about.