The joker in the pack this year has been the Indian rupee. At a time when the Indian and Chinese economies may be the last men standing, the rupee – unlike the Chinese yuan – is into steep decline and fall.
On Tuesday, the rupee hit a two-year low of 48.24 against the US dollar, suggesting that short-term demand and supply issues are determining its value when the macro-fundamentals should actually lead to a strengthening of the Indian currency.
The financial markets are clearly divorcing from reality – though in the long term they will surely correct.
There is, of course, one good economic reason for the rupee to fall. It's the growing trade deficit (imports minus exports), which hit $55 billion in the April-August period this year. Unless this deficit is bridged by capital flows, the rupee has to decline. Even the Reserve Bank cannot keep selling dollars – which it has shown no great inclination to do —to stem its fall.
The rupee's drop is complicating the fight against inflation. We are now importing inflation (whether it is through higher oil prices or something else), and this will push the Reserve Bank to keep raising rates till something gives.
As against this downer, two other macroeconomic indicators are a relative positive for us.
One of the key determinants of exchange rates is relative interest rates, adjusted for inflation. US policy rates are near zero, and will stay that way, while Indian rates are at 8.25 percent. The US inflation rate is 1-2 percent above the policy rate; ours is, too. This means there is no greater risk in the Indian currency than the US dollar. Sooner or later, capital flows should be headed our way, strengthening the rupee in the process.
Second, India scores on the growth potential front when compared to the US and Europe. No matter how much we slow down, we will still be growing 6-7 percent faster than both these big trading partners. This means capital should be flowing away from the dollar and eurozone, and towards India.
Then why is the rupee showing no spine?
Once inflation is down, the rupee will start moving up towards it medium trajectory of appreciation. Photo:Flickr/Creative Commons
One explanation, of course, is global risk-aversion, which is making capital seek safe havens. To be sure, there is no real safe haven in the world today, given the volatility of every currency, the threat of double-dip recession in the US, and the shakiness of most financial markets.
In fact, faced with the prospect of a eurozone collapse, money has been flowing into Swiss franc and the Japanese yen. This has forced the Swiss central bank to draw a line in the sand saying it will not allow the franc to rise above 1.2 against the euro. It will buy unlimited quantities of the euro to do this. The Bank of Japan also unleashed a tsunami of dollar purchases in August to prevent the yen from rising.
The joke is really on the concept of safe havens. Switzerland, whose banks handle assets that are six times its GDP, is really the most vulnerable of them all. A major bank collapse can bring down the Swiss economy, even as the world pressures the Swiss to wind down their support for global tax evaders. This is why the Swiss are planning to raise capital adequacy norms for banks to 19 percent.
Britain, which is home to huge global banks that are "too big to fail" and will need rescuing by the government in case there is a run on them, is planning to mandate at least 17 percent capital adequacy. The assets of British banks are 4.5 times its economy.
As for Japan, the less said the better. How can an economy with two decades of almost no growth and a domestic debt twice the size of its stagnant GDP, really be a safe haven? The only way Japan can keep the yen down is by unleashing another tsunami of yen debt – which will only worsen its macroeconomic stability. Japan is still an economy waiting for the ultimate implosion.
In that ultimate safe haven, the US, national debt more or less equals GDP, and the Obama administration is trying to cut down expenditure to make sure it stays solvent. But here's the sobering thought, according to David Rosenberg, who says the US economy is facing a double-dip recession, having accumulated $5 trillion of debt in just the last three years – to avoid a depression.
Europe is ticking time-bomb. The betting is that the euro will soon see some opt-outs like Greece and possibly Portugal. But even if Germany is blackmailed or cajoled into bankrolling the euro, the only consequence will be slower growth and economic uncertainty. Everyone knows that Greece is insolvent. The only way it can be rescued is by asking banks to take a "hair-cut" – that is write off some of their Greek debt. This, again, means German banks have to recapitalise themselves. They need capital.
In sum, the US isn't a safe haven, Europe isn't one, Switzerland does not want to be one, and Japan isn't anyone idea of a safe haven.
The only certainty is the prospect of slow growth, and a reduction is consumption and wealth, says Satyajit Das, a risk consultant and author of Extreme Money. In an article in DNA newspaper, he says:
"The proximate cause of recent volatility (in markets) is the down grading of the credit rating US (irrelevant) and the continuation of Europe's debt problems (relevant). The deeper cause is the realisation that future growth will be low and the lack of policy options."
So what will happen now?
"The most likely outcome is a protracted period of low, slow growth, analogous to Japan's Ushinawareta Junen — the lost decade or two. The best case is a slow decline in living standards and wealth as the excesses of the past are paid for. The risk of instability is very high; a more violent correction and a breakdown in markets like 2008 or worse are possible. Frequent bouts of panic and volatility as the global economy deleverages -reduces debt- are likely. Problems created gradually over more than the last three decades can only be corrected slowly and painfully," says Das.
Now, if Das is correct, capital flows should be moving away from US, Japan and Europe – which are heading for slow growth and even wealth erosion – and towards where they are more likely to show positive results: India, China and the emerging markets.
The conclusion, therefore, should be two-fold: in the short run, as western investors and banks worry about their problems back home, and seek to hoard capital against the prospect of huge losses from bad loans, there will be great risk aversion. This is why capital flows into India this year are down 80 percent from last year already.
However, the long-term prospects will depend on how soon investors in the rich nations redefine their mental idea of a "safe haven." When this happens, India will face a tsunami of capital flows, which will reverse the trend in the rupee.
Some research reports doubt whether this will happen too soon. A Deutsche Bank report dated 15 September says it has revised its long-standing view that "the exchange rate is poised to display a tendency toward medium term appreciation, as India's high growth potential would allow it to attract foreign capital and hence it would run an ample and steady balance-of-payments surplus. This view has run counter to the argument that India's persistent current account deficit and reliance on commodity imports make the exchange rate unlikely to sustain trend appreciation."
So what is Deutsche Bank really saying?
"We now see an additional force complicating the debate: inflation. The persistence of high inflation over a number of years is bound to impact the economy's competitiveness…Furthermore, latest estimates of India's purchasing power parity-based exchange rate also show that one needs substantially more local currency to purchase an internationally comparable set of goods."
"Going forward, one can envision one of two scenarios — either India brings down inflation sharply to stem the rise in the real exchange rate, or it succumbs to a bout of nominal exchange rate depreciation. This issue is independent of the ongoing bout of global risk aversion. We see the rupee's vulnerability rising unless inflation is brought back to the previous trend of 4-6 percent."
This explains the recent weakness of the rupee. It also suggests that the Reserve Bank cannot afford to pause on rate hikes till the back of inflation is broken. Once inflation is down, the rupee will start moving up towards it medium trajectory of appreciation.
Put another way, succour on capital flows are vitally dependent on the battle against inflation.
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