Column Falling down

Written by Indranil Pan | Updated: Jul 13 2008, 03:57am hrs
India was until recently a goldilocks economy, where growth was strong, inflation low, stock markets went up at a rapid pace and rupee liquidity was humongous, thanks to the dollar mop-up operations of RBI. The goldilocks situation led to vociferous support to the decoupling argument and for the foreign exchange market it meant a consistent pressure for the rupee to appreciate. The more the appreciation, the better it was for the flows.

In the FY till date, among the Asian currencies, rupee lost the maximum, by nearly 8%. This was probably on the cards. The currencies that are likely to have been most vulnerable were the ones where the monetary policy response to fight inflation was perceived to be inadequate, combined with trade and/or current account deficits. To put this in perspective, India managed to afford higher trade deficits as the capital account surplus also moved up in tandem. In FY06, FY07 and FY08 the trade deficit was at $51 bn, $63 bn and $90 bn while the capital account surplus was at $25 bn, $46 bn and $108 bn.

Now, the currency has been hit by a sudden and sharp rise in oil prices. India had exhibited its vulnerability to oil price shocks in the past too as it imports around 70% of its crude requirement and the oil import bill is nearly 30% of its total import bill. The rise in the oil prices till around March did not create much of a problem as the additional demand for dollars for oil imports could be adequately met through dollar supplies via the capital account route. The problem now is that the flows have also dried up.

The situation could get worse on the oil import bill as a 40% rise in the crude oil prices in barely 6 months has led to some harsh projections on international crude oil prices. The oil market has become unpredictable as the prices are being pushed up by a wide array of factors: a weaker dollar, a possible long-term scarcity premium etc. Even Opec is of the view that crude could go as high as $170 a barrel this summer. Calculations indicate that if crude oil prices average at $130 bn in FY09, the oil import bill will be at $124 bn but as crude oil prices move higher by $20 a barrel, it would be at $148 bn, leading to a jump in the trade deficit by around 12%.

The big problem is that the scenario on the capital account has altered completely. One of the big components of capital inflows, namely FII inflows into the equity markets have lost steam with the excess liquidity now flowing out of Asia rather than into Asia. In the calendar year till date, FIIs have pulled out around $6.5 bn from India. With continuing de-leveraging of global financial institutions, it is unlikely that large amounts of capital would immediately be diverted to emerging markets. With the RBI now clearly in a mode to fight inflation and, therefore, raise interest rates further, the negative impact of this is expected to be felt on economic growth and reduced corporate earnings. Clubbed with the recent spate of political uncertainties, the Indian equity markets might not look as attractive as they used to for the FIIs.

External commercial borrowings are also expected to slow down due to quantitative ceilings imposed on rupee expenditures from funds raised through this route. The willingness as also the capacity of the global financial institutions to lend to Indian corporates has already been on the wane and is likely to remain so in the near future as the stress in the global financial markets continue. Overall, the scenario appears grim for the balance of payments. Kotak Banks estimates indicate that as the capital account surplus halves in 2008-09 from 2007-08 and as the current account deficit rises, the Balance of Payments surplus is likely to shrink to only around $10 bn if the average price of oil stays at $130 bn a barrel. Oil prices higher than $140 a barrel will lead the balance of payments to dip into a deficit.

The above scenario entails that rupee could stay under depreciation pressure for most part of the remaining fiscal. Rupee could have been weaker than the current 43 to a dollar if it were not for the recent measures by RBI to attract more inflows through some relaxation in the FII limit for debt and the ECB ceilings. The supply of dollars was also enhanced through the Special Market Operations that enables oil companies to obtain dollars directly from the RBI by using oil bonds.

In the current unfolding scenario, RBI might be wary of stemming the depreciation of the currency by releasing large doses of forex reserves, though it can try and contain sharp movements on any single day. For one, the changing risk contours of the global financial markets might make RBI risk averse and save up the forex reserves for any unforeseen circumstances later. Further, appreciating the rupee could lead to rise in cheaper non-oil imports, a scenario that goes contrary to RBIs stated objective of trying to reduce aggregate demand. Appreciating the currency could also kill growth further by limiting export prospects in a scenario when anyways the interest cost is likely to remain on the higher side.

The author is chief economist, Kotak Mahindra Bank. These are his personal views