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Exchange Rate - Gravity pulls

Sep 28, 2007

Mr. Bernanke's Feds Fund rate cut may have played to the markets but has otherwise achieved precious little. The yield on treasury bills with maturities above fifteen years (the term for most mortgages) has actually gone up by 20 basis points. Instead of easing liquidity domestically, it has driven dollars into other markets around the world where they are allowed to buy assets with higher returns. And this is the root of India's sensitivity to the Federal Reserve's actions. Within a week, the stock markets jumped up to the hitherto tantalising heights of 17,000, setting a record of the highest-ever continuous climb of 1,600 odd points within eight trading sessions. And what is pertinent to this article today, the Rupee started gaining in value against the dollar. The general weakness in the dollar itself was one reason. At the same time, demand for dollars has been tepid with non-oil imports showing signs of slowing down. A sudden inflow of US$ 1.2 bn into Indian stocks has thus seen the Rupee getting strengths not tested since 1998.

Inherent strengths in a currency
India was the second fastest growing economy in the world in 2006. The potential for her continuing growth exists. And most importantly, it is her domestic consumption that will drive this growth. But there are miles before India's currency can command the respect that the dollar has for almost the whole of twentieth century. Even today the US accounts for one-third of the world's nominal GDP and 20% if the GDP is calculated on a Purchasing Power Parity basis. It is the world's largest importer and its second largest exporter. This eminence of the US economy has made dollar the currency of international trade, and of foreign currency assets.

In the last five years, India's share of world trade has increased. But it is still a miniscule 1.2% and most of it is thanks to her software exports. India is saddled with twin deficits just like the US. She has a current account deficit of about 2% of GDP and also a fiscal deficit of 5%. Though it seems more manageable in front of the US current account deficit of 8.6% of GDP, the US has capability of bouncing back into balanced budgets on the fiscal front. That reduces its constant need for capital. This is a feat that India has not been able to replicate. With the public sector acting as a drain, India will forever be requiring funds. This will keep the Rupee at the mercy of fluctuating dollar inflows.

Limited by choices
To shield India from the vagaries of the dollar fluctuations, there are many options, all with some tough decisions involved. The question is how the authorities prioritise them. Should investments be limited to domestic savings? Savings have their own cycles, depending on income growth and real interest rates. But normally they tend to be in a band of 25% to 32% of GDP.

As of today however, majority of this is funnelled into financing government deficits and on paying salaries of its employees through small savings, Provident Funds and Insurance Funds. By freeing up end use of insurance and pension schemes, the productivity of money easily be improved to keep real growth at around 8% - 9%. This eliminates the necessity of borrowing in dollars or for that matter waiting for Foreign Direct Investment to build our infrastructure for us.

A strong central government is the necessary premise for this argument. A government that can reduce the Rs 26,331 bn internal debt by either selling assets (will have the Left parties baying all over again) or then drastically cut expenditures of the ministers, ministries and their entourages along with the bureaucracy. With the current coalition in place, this course looks impossible for the next twenty months or so.

The easier option might not work in the short run
The Reserve Bank of India (RBI) has opted for the easier way out by allowing more money to leave the Indian shores. We have a sneaking suspicion that this freedom will not mean increasing demand for dollars as yet with domestic growth bettering the global average. Given the lack of global expertise, not many will opt to invest abroad either especially when the returns on Indian stocks are far better than in most countries.

Global flows hold the key
Strategic investments in Indian companies by private equity funds has seen an inflow of about US$ 10 billion over the last five years through India specific funds. Most of that money will stay. What can cause future upheavals is the fate of the highly leveraged foreign hedge funds. As lenders worldwide play safe with their funds, these funds will find their sources drying up, and thus they will retreat from the 'emerging markets'. For 2007, the IMF forecasts a reduction in private capital flows from US$ 256 billion in 2006 to US$ 253 billion. Almost 9% of these inflows came to India.

As the world plays safe, not only will inflows dry up, the investors might want to encash gains in India to tide over difficulties faced in other markets. This reverse flow will then pressurise the Rupee to depreciate against the dollar, just as it has appreciated today thanks to the inflows. The other and infinitely harder consequence will be in the drying up of the price advantage India has over the rest of the world as the Rupee strengthens so fast. This will reduce profitability and growth in India that had ignited interest in the economy after all these years. Then all the fair weather investors will go away hunting for newer pastures, while the Rupee gets back to a more realistic exchange rate and begins the cycle once again.


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