Can the Rupee be left alone? - The 5 Minute WrapUp by Equitymaster
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Can the Rupee be left alone?

Nov 29, 2011

In this issue:
» Roubini does not believe in the Gold Standard
» Which economy can maintain high debt levels?
» Parameters outlined for PSU banks
» Private sector credit in China is high
» ...and more!
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The rupee's steep fall against the US dollar in recent weeks has been the result of deteriorating conditions in the European region, which has led many investors to pull out money from both Europe as well as emerging markets such as India and park them in the dollar. Especially in India, breaching the Rs 52/US$ mark, this slide only raised fears of more pressure on inflation which has already been persistently high for quite some time now.

Interestingly, the RBI, which in previous years had been active in intervening in the exchange market, has chosen to stay on the sidelines. Its stance being that market forces should determine the value of the rupee and that it would intervene only if it observes heightened volatility in the Indian currency. In the meanwhile, India Inc. has bore the brunt of the sudden fall in the rupee. Many corporates which had hedged their earnings at higher rates, not imagining such a drastic slide, have had to contend with forex losses. Same has been the case with companies importing larger chunk of their raw materials who have had to pay a higher price for the same. As is the case with companies with large amount of foreign currency loans on their books that have had to book forex losses.

Little wonder that many of them are keen that the central bank does something to stem this slide. So is the Reserve Bank of India (RBI) right in not bowing down to this pressure? One of the reasons that the RBI may not be intervening in the markets is due to the current quantum of forex reserves. These seem to have fallen and the central bank does not want to use these reserves solely for the purpose of controlling the currency. Indeed, given how uncertain the environment in Europe is, one cannot ignore the possibility that any intervention by the RBI would still not have stopped the fall of the rupee. Thus, global risk aversion and India's widening current account deficit would have forced the rupee to fall further against the dollar despite the intervention.

Therefore, no intervention means that participants will have to adjust their investment, consumption and borrowing plans according to the availability of foreign capital and import costs. Thus, if the quantum of imports reduces and exports rise, it could ease some pressure off India's widening current account deficit. At the end of the day, the value of any currency should be determined by the economic scenario and market forces. Thus, as long as India continues to harbour a widening deficit and the global economy continues to deteriorate, no amount of intervention by the RBI would do much in stemming the slide in the rupee.

Do you think the RBI is right in not actively stopping the slide in the value of the rupee? Share with us or post your comments on Facebook page / Google+ page.

 Chart of the day
Today's chart of the day shows that China's private sector credit (as a % of GDP) was on the higher side in 2010. Indeed, Chinese banks have lent indiscriminately to its property market and had raised fears of an asset bubble already forming there. In contrast, private sector credit in India has been lower. This could be attributed to higher borrowing costs in the country which has dampened appetite for debt and consequent slowdown in bank credit in the country.

Data Source: The Economist

American economist Nouriel Roubini accurately rang the alarm bells well before the recent recession hit the US. Now, he is throwing brickbats at gold bugs. No, he is not saying that gold prices are going to fall. His criticism is aimed at gold standard fans. To put in his own words, "Those making public calls for a return to the gold standard are a bunch of lunatics and hacks who are doing nothing but calling for a repeat of the Great Depression." Well, to give you a brief background, the critics of the US Fed's loose monetary policy and reckless money printing have often argued that a return to the gold standard would make sure that the government lives within its means. And this would, in turn, curb inflation which results from money expansion. Sounds fair, isn't it? But let's also see what Mr Roubini's reasoning is. According to him, the gold standard was one of the major causes of the Great Depression of 1929. Why so? Because by limiting the amount of money in the economy, the gold standard restrained the central bank's ability to intervene in the time of crisis as lender-of-last-resort.

We don't quite agree with Mr Roubini on this. Isn't the failure of quantitative easing (QE) post the financial crisis of 2007-08 enough proof that money printing is not really a solution? The simple truth is that economic illnesses cannot be cured with monetary pills. And by pumping in money in the economy and by bailing out big banks, the US government has only aggravated the problem.

Keynesian economics now having taken a bow with its failure to take the Western world out of the debt spiral, modern economic theories are finding stronghold. Economists Carmen Reinhart and Kenneth Rogoff's theory on sovereign debt levels have assumed more importance than ever before. The economists opined that sovereign debt levels become unsustainable when they rise above 60-90% of a country's gross domestic product (GDP). The theory rests on the fact that tolerable sovereign debt depends on a several factors including, the interest rate on debt, the debt maturity profile and the economy's growth potential. A dynamic economy capable of high levels of growth, with the ability to generate additional tax revenues and attract investments, can maintain a higher level of debt than one with lower growth prospects. Going by this logic, an article in Financial Times claims that if Italy's borrowing costs were 4%, with debt-to-GDP ratio of 120%, the country would need to grow at 4.8% per annum to avoid increasing its debt burden. However, at current market borrowing costs of 7%, Italy will have to achieve a highly unlikely growth rate of 8.4% just to avoid increases in its debt levels. Hence the combination of high sovereign debt and low growth rate has become a lethal combination for the economy.

PSU banks have not been the most favoured stocks with investors over the past year. Deterioration in asset quality and slowing economic growth has caused these stocks to correct sharply over the past year. In order to improve their lot, the Finance Ministry has come up with a few parameters that these banks have to achieve over the next four years. They will have to achieve targets in terms of current and savings account (CASA) deposits, return on asset, cost to income, asset quality, etc. But this is not going to be an easy task. PSU banks have to disburse loans to priority sectors, and agricultural and SME loans usually suffer from lower asset quality. Plus these banks have an inflated employee base and have to set up branches/ ATMs in rural areas or semi-urban areas thereby increasing their cost of operations. Also having a compulsory 40% CASA base may lead to cutthroat competition for these low cost accounts. We hope these targets don't do more harm than good.

"The elephant dance was interrupted by the 'zoo party' of the global financial crisis. To get it back on course, we need to rejig the dance". Nonchalant and humorous as this may sound, RBI governor Dr Subbarao's words on the way forward for the Indian economy are impactful nevertheless. The central banker who has been criticized for being too laid back when it came to inflation control, believes that nothing has gone horribly wrong with India's long term growth story. On the contrary he believes that achieving inflation rate close to 5% (nearly half of current levels) is also possible. Dr Subbarao also reiterates that fiscal discipline long term infrastructure funding and financial inclusion can go a long way in improving India's growth prospects. The annual infrastructure investment for instance, would have to be increased to 10% of GDP from the current 6% to meet the requirement of US$1 trillion over next five years. Similarly, corporate debt market will have to be overhauled to meet the country's domestic saving and investment needs. While we cannot confirm Dr Subbaro's inflation targets, we certainly agree with his views on the sanctity of India's long term growth story.

In the meanwhile, the Indian stock markets were underperforming the Asian peers and were trading in the red in today's session. At the time of writing, BSE Sensex was down by 77 points (0.5%). Oil & gas and IT stocks were the biggest losers. However, healthcare and auto managed to trade positively. Asian stock markets displayed an upbeat mood with Japan as the top gainer (up by 2.3%).

 Today's investing mantra
"Even with a margin [of safety] in the investor's favor, an individual security may work out badly. For the margin guarantees only that he has a better chance for profit than for loss - not that loss is impossible. But as the number of such commitments is increased the more certain does it become that the aggregate of the profits will exceed the aggregate of the losses." - Benjamin Graham

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3 Responses to "Can the Rupee be left alone?"

sarvotham yerdoor

Nov 29, 2011

The depreciation of rupee has been partly on account reckless fiscal policies of the central govt. which is having a deleterious effect on the economy and current account deficits. RBI intervention to shore up the rupee would only cover up the follies of the politicians and the govt. If RBI is able to successfully resist the pressure, the govt would be forced to tread a responsible path.



Nov 29, 2011

What the European crisis is teaching us (as well as the 2007-08 US crisis) is that in the current globalized marketplace, sovereign currencies can no longer efficiently function as exchange mediums. The root of the problem is simply the fact that sovereign currency is a measure of indebtedness of that country. The more indebted the country is willing to become, the more the currency of that country is available, and vice-versa, if you need more currency of a country, it has to become more indebted.
Questions every Indian citizen must introspect upon:
1. Why is RBI having a foreign exchange reserve at all? Who is it for? Indians? How will it be used? To purchase oil? Food? Who will take it from RBI and go to other countries and import? The Govt? In a market economy, why should govt get into import/export of stuff?
2. Another angle, how did RBI come to acquire 300b in forex reserves? Did it purchase from the forex market? If so, where did it get the rupees to purchase the dollars? Did it print them out of thin air? If so, is this legal? If legal, is it the right thing to do?
3. Do other countries have forex reserves? China does at 2T, japan has 700-800b. Does US have it? No? Why not? How about countries in Eurozone? No??? Amazing! These 2 'developed' regions are among the most suffering economies in last 5 years and India/China/Japan is holding 'reserves' which means they are indebted to us. With their economies in tatters, how will they service this indebtedness? Oh...I remember, they won't! US has already a ZIRP in place for last 3 years, which will likely continue for another 3-5 years at least. Why is RBI holding on to non performing currencies as reserves? particular those that are not only not paying any interest, but rapidly devaluing due to excess govt spending and money printing?


Ganapathy Sastri

Nov 29, 2011

It is absurd to blame RBI or Finance Minister for the exchange rate of INR vs another currency. In the first place, European troubles are not the cause for the change that has occurred in the value of INR vis a vis USD. Everyone who had an interest in a particular exchange rate for the rupee has been taken by surprise at the fall of the rupee and hopes for good old days.
The fact is WE THE PEOPLE OF INDIA are responsible for the fall in the value of INR. The market is very discerning and distinguishes strong currencies from weak currencies. The major causes for the fall in the value of the INR are:

A. MASSIVE INFLATION ( over 15% CAGR during last three years) in everything - wages, goods and services, real estate, rentals.

B. MASSIVE TRADE DEFICIT exceeding USD 150 billion year after year.

RBI did the right thing in not selling dollars of which it has only limited amounts. Also we do not the NAV of the country. While RBI says we have reserves of USD 315 B, how much debt does the country have? If you prepare a balance sheet of INDIA INC. the picture may be grim.

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