Unnerving volatility

Implications for India

The economic situation in all three major advanced economies is getting worse. The sovereign debt crisis in Eurozone is getting out of control with Greece (may be followed by a few others) sliding towards default. This has the potential of seriously undermining the health of the banks in Europe and America that have directly or indirectly lent money to the troubled countries like Greece, Portugal, Spain and Italy.

Even Germany, the robust growth engine of Europe, has come close to zero growth. US growth has come down to 0.1 per cent in the last quarter and unemployment rate is remaining stubborn at around 9 per cent. Fed has promised to keep short term interest rates at zero for the next two years. Nothing much can be done on monetary policy front.

On fiscal policy, increasing government expenditure and cutting taxes to stimulate the economy are being stalled due to strong political opposition to any further increase in public debt. Japan is having negative growth. Even high growth emerging economies like China and India are showing signs of a slowdown along with a spurt in inflation.

As a result, rather paradoxically, global investors are moving money from assets denominated in Euro,Yen and other currencies to the ‘safer’ dollar-denominated US government bonds, despite S&P recently downgrading US government’s credit rating. US dollar is going up relative to all other major currencies. Indian rupee has reached its lowest value in 28 months, falling by 2.6 per cent in a single day.

The stock markets all over the world including India have also suffered huge losses as investors are shifting from risky equities to safer assets like US and German government bonds and gold.

India’s problems are much more serious than China’s. India has a higher rate of inflation, higher and rising budget deficit, high and increasing current account deficit (China has a big surplus) and much lower foreign exchange reserve cushions (USD 300 billion against China’s more than 3 trillion).

Though slowdown in the west may affect Chinese exports more than India’s, our overall balance of payments and hence the exchange rate is much more vulnerable as we rely heavily on fickle foreign portfolio funds (rather than the more stable foreign direct investment) to finance our deficit. Our stock market, too, is more volatile because of the importance of foreign institutional investors in Indian equity market.

Rupee depreciation
Who is to gain and lose from the rupee depreciation? Broadly speaking, exporters will gain as their exports will become cheaper abroad (in US dollar) which means greater demand for their export products. Also, the rupee realisation from their dollar export earnings will increase. Thus, Indian software companies would gain as the prices of their services are usually fixed in dollars. But, at the same time if there is a prolonged slowdown in US and Europe, the volume of their business in those countries would shrink.

Firms which import raw materials from abroad but sell finished products in the domestic market would lose as the rupee cost of their imports will go up but the domestic prices of finished products may not move up proportionately. Indian oil refineries which import crude and gas from abroad but sell refined oil like diesel, kerosene or cooking gas at government administered prices belong to this category. By similar logic, the net impact of rupee depreciation would be small for the firms which finance their imports with dollar export earnings. Their gains from higher export earnings in rupees will offset the losses from higher rupee import cost.

Many top rated Indian companies have borrowed in US dollar from the international market specially as the interest rate in India has been climbing higher in recent times.  Those whose interest and loan repayment obligations  are fixed in US dollar will suffer. The cost of  buying protection against future exchange rate fluctuation (‘hedging’) will increase  as the market would expect greater volatility of the rupee-dollar exchange rate over the next few months (or even years) till the global economy stabilises. As imports become costlier and more exports reduce domestic availability of goods, the already high inflation rate may get a further boost.

How about the chances of rupee rebounding in near future?  Two factors will be important. One, how the RBI will intervene. The truth is that RBI does not have adequate dollar reserves to sell to the market to reverse the trend of rising dollar relative to rupee.

If it tries, it would lose reserves and pretty soon its reserves will become dangerously low. So, at best we can expect RBI to intervene on a small scale and sporadically to curb excessive fluctuations in the exchange rate, instead of trying to reverse the trend.

Two, if the global slowdown persists for some more time, the global prices of commodities – specially crude oil and metals – would fall. This would  help the Indian balance of payments, reduce the inflation rate (a large part of which is imported inflation) and raise the price of rupee.

Also, if the US and the Eurozone show no signs of recovery, eventually money has to return to emerging markets like India in search of profits. The Indian growth story, though less credible than before, may still become more attractive   than the growth story in the western world.
(The writer is a former professor of economics at IIM, Calcutta)