Sunday, August 25, 2013

Observations on India's currency crisis

The rupee's slide continues. Apart from adverse global headwinds, triggered off by the uncertainty associated with a tapering of the quantitative easing in the US, the Indian economy has been battered by three weaknesses - persistent high inflation, large fiscal deficit, and unsustainable current account deficit. It was natural that, atleast in the short-run, the value of rupee decline since it was losing competitiveness both internally (due to inflation) and externally (due to greater demand for foreign currency).

In this context, I have three observations.

1. One of the most worrying things about the crisis is the potential adverse impact of a falling rupee on the external debt sustainability of Indian corporations. They have raised $ 50 bn in loans over the past four years, buoyed by the ultra-low interest rates abroad and an environment which favored large capital inflows into emerging economies. Many commentators had strongly supported such capital financing, on grounds of cost efficiency and others, and the RBI too had successively eased external commercial borrowing restrictions. Since most of these borrowers had their revenues in rupee, any depreciation of rupee was certain to adversely affect them. Interestingly, the raising of external debt continues unabated, and no body appears to be calling for some restraints on it.

This should be a strong reminder to the advocates of unhindered capital flows about its potential dangers. Market participants, in this case our corporations, swim with the tide and rarely exercise rational restraint when the times are good. Regulators should exercise caution and refrain from pro-cyclical measures, even in the face of vociferous support for such measures, when the markets are on the upswing. This is only the latest episode of private corporations running up large external debts in a capital flow cycle, only to endanger their country when the cycle reverses. And we still learn nothing from such recurrent episodes.

2. Commentators have been accusing the government for not doing much to escape the crisis. While the government undoubtedly bears the major share of the blame for having allowed things to get this worse, there is little that it can do now to avoid some period of suffering. Those who call on the government to "do something path-breaking and far-reaching" do not realize that there are no such silver-bullets. The deep structural problems of the Indian economy have been exacerbated by a self-fulfilling downward spiral of negative sentiments that have gripped the perceptions of Indian economy.  

The former is a very serious battle to be fought later, though reforms have to be initiated now. And backstopping the downward spiral and reshaping expectations is a not a matter that is easily addressed, even by the most proactive of governments, leave aside governments with deeply eroded credibility. In any case, even the most appropriate policy measures start impacting with a reasonable lag, which is often time enough for the economy to spiral further down. It is evident that we over-estimate the ability of the government to do much in the short-term, though this is no excuse for the government to delay taking steps to lay the foundations for a sustained medium-term recovery.

Further, as I had blogged earlier, all talk of letting the rupee find its fair value, betrays a failure to appreciate the complex dynamics of international foreign exchange markets.

3. I also feel that the criticism of the RBI for its failure to stay the course with monetary tightening may be a bit unfair. It is in effect blaming the RBI for the government's failures. It was a big step of independent decision making, even by the standards of any central bank, for the RBI to so decisively raise rates in July defense of the rupee. It had to overcome stiff resistance from its own government which faces an election and private corporations who were badly hit by the rise in rates. I see nothing wrong with a three-steps forward and one-step backward strategy, where a very decisive intervention is followed up with small compromises. It is of course a matter of debate as to what degree of back-tracking is tactically sound.

Monetary policy making in such times is about pragmatism and consensus building, and not pursuing the ideal or even the second best alternative. A too independent and theoretical a central bank runs the risk of allowing an Abenomics style take-over. After all it is not too much of a stretch to imagine that the government would have made the environment impossibly difficult for the RBI if it stayed its ideal course too far. In this context, it will be interesting as to how an untested Raghuram Rajan will navigate the crisis. 

No comments: