By Mihir Baxi
In a brilliant Forbes Magazine article, Kenneth Rapoza states the reasons he believes India to be the darling of Wall Street among emerging market countries – a stable government, no civil strife or war, no trade drama, and a respected central bank. There certainly are some items in India’s economic history which are ripe for criticism – from the dilemma of non–performing assets in the banking system to the demonetization drama last November. But all things considered, the Indian economy has performed quite well. The often quoted expression “May you live in interesting times” is certainly applicable to India’s economy, as it deals with a new VAT regime, a cash purge, an equities rally, and a currency appreciation. The last of these variables that make for our so called ‘interesting times’ (admittedly by me) should be the subject of further perusal, and will help address some concerns about Indian Trade Balance, Foreign Investments, and Monetary Policy. In early August of this year, the Indian Rupee appreciated to 63.67 against the dollar, its highest value since August 2015. Much of this appreciation can be attributed to strong capital inflows into the equity and debt markets. India’s recent equity market surge – which boasts gains of 18.95 per cent (Sensex) since January; as well as the Reserve Bank of India’s (RBI) relatively hawkish stance on monetary policy has driven foreign capital into the country.
Capital inflows can be attributed, besides solid economic fundaments and healthy returns on equities and debt, to two political factors as well. Firstly, the US Dollar has been losing pace globally, with investors losing faith in President Donald Trump’s ability to deliver on his administration’s agenda – chiefly his campaign promises concerning tax cuts and infrastructure investment. The US Dollar Index (DXY) dropped by more than 10 per cent between January and early August, and during the same time net positions on the dollar reduced from a net long position of $30 billion to a net short position of $7.4 billion. This is the most lugubrious that investors have been about the US dollar since 2014 (according to Business Insider). In India, on the other hand, Prime Minister Narendra Modi’s Bharatiya Janta Party (BJP) has consolidated power further through its sweeping Assembly Election victory in March. More than $3 billion were poured into Indian markets by Foreign Institutional Investors after the conclusion of these state elections. This inflow certainly increased both domestic and international confidence in the Indian economy, especially given the $4 billion outflow from November 2016 to January 2017, which resulted from the Modi administration’s demonetisation policy. Capital flows, through Foreign Direct Investment and Foreign Portfolio Investment, nonetheless flowed into India and played a role in matters of currency gyrations.
The Rupee having strengthened far more than emerging market peers, Indian exports are vulnerable to a loss in competitiveness against peers like Thailand, China and Bangladesh. As its global emerging market peers face a relative currency depreciation and can thus rely more heavily on exports, Indian industries have a cause for concern. Companies in countries like Bangladesh and China have cut prices to boost their competitiveness against their relatively expensive Indian counterparts. Business Standard recently reported – citing industrial sources – that Indian companies’ exports are now 10 percent more expensive than their competitors in countries like Sri Lanka and Bangladesh. Exporters usually hedge against currency volatility, but premiums on hedging increase substantially after two quarters, making the process difficult in the medium to long run. This appreciation also comes at an unfortunate time, given the newly implemented Goods and Services Tax (GST). This new VAT regime could have significant benefits in the medium to long run in terms of growth and consolidation. However, India has witnessed a depression in export growth since the enactment of GST last month as a result of the possible short run inflationary impact of the policy, the time it takes to implement a VAT across the entire supply chain, and the increasing strength of the Rupee. Exporters in India have witnessed declines in orders from abroad, much of which can be attributed to the appreciation, and perhaps to caution until the complete implementation of the new taxation regime.
That the Rupee appreciated against both the dollar and the Chinese Renminbi, it is likely imports from China could increase to more than $61 billion. The relatively cheap Chinese imports are flooding into India and are thus hurting manufacturing further. Gains in equities could fuel further appreciations in the short run, which may increase the number of importers who aren’t hedging their currency exposure. In the fiscal year 2014-15 total imports stood at $448 billion, this number fell to $380 billion in 2016-17. The principle cause of this drop is the precipitous fall in prices of oil and other commodities, which substantially reduced India’s import liabilities. Yet, in the same period, non-oil imports remained at a steady level. In fact, India’s share of world imports rose due to the appreciating rupee making imports more affordable than domestic manufacturing. This hurt the profitability of domestic firms and increased the trade deficit (as reported by Livemint). The resulting contraction of domestic demand slowed growth to a level that is lower than what it would have been without the appreciation.
A monetary policy response to the Rupee appreciation has thus far not occurred, due to the immense liquidity in the Indian economy – which boasts a systemic surplus of $62 billion. Additionally, the appreciation is largely seen as a temporary phenomenon by the RBI. With an expected moderate rise in inflation, and a slight probable increase in current account deficit, a depreciation in the medium to long run is possible. Measures of the Real Effective Exchange Rate, which compares the Indian Rupee to a basket of other currencies, suggests that the Rupee is overvalued. The degree of this overvaluation varies depending on the currencies which are included in the basket to which the Rupee is compared. An average of all Real Effective Exchange Rate models, as suggested by Nomura, implies a probable 2 percent overvaluation of the Rupee. It should be noted that exchange rate models are quite complex, and it is difficult to pinpoint an accurate estimate of currency values. While an aggregation of multiple models is quite simplistic and predicting exact numbers is often nebulous, a directional suggestion of an overvaluation is an appropriate prognosis to espouse. A depreciation should thus be expected.
The source of any depreciation to come can either be investors pulling out of India or domestic policy action. In the case that expected returns are higher abroad, investors might rush out of India and in so doing depreciate the currency. Investors might flee upon witnessing a sign of turbulence in Indian markets, the most likely source of which is the rate of default on bonds and syndicated loans, which has quadrupled this year, and the disclosures of non–performing assets in the books of state owned banks. The dynamics of the process of capital outflow can be explained through a simple price and demand framework — as investors sell Rupees to buy any other foreign currency, the value of the Rupee decreases relative to the foreign currency in question, making the Rupee cheaper.
Alternatively, it is conceivable that the RBI cuts interest rates further, making the servicing of debt easier and ameliorating the soporific rate of credit growth in India. A rate cut would also have the effect of depreciating the Rupee, stimulating exports and in turn, domestic investments. Such a demand side growth push would be beneficial for the real economy, and could conceivably bring the rupee down from its overvaluation. A sharp depreciation would put inflationary pressure on the economy, stymie capital inflows and expand the deficit. Durable consumer goods can especially be expected to see a rise in prices if the Rupee undergoes an unchecked depreciation.
With a record low inflation rate of 2.36 in July 2017, some increase in inflation should not be feared, especially when the current rate is juxtaposed against the RBI’s 4 per cent target. With key interest rates at 6 per cent, an increase in rates to combat any potential inflation in the medium run is not a desirable outcome, given that the cost of borrowing in India is significantly higher than its peers with similar levels of per capita income. Rates in India have been quite high for the better part of the last half decade, in line with the RBI’s hawkish anti-inflationary stance. In the short run, the RBI should to cut rates further so as to bring the rupee to a healthy level, and in so doing stimulate growth and investment. Such an RBI rate cut should be expected in the short run.
The healthy bull market in India will hopefully sustain its gains in the face of a moderate depreciation. In the recent past, the Rupee faced a sharp depreciation between May and August 2013, and a more moderate but sustained depreciation between May 2014 and February 2016. In the former – and more dire – of these two depreciations, capital outflows fueled a decrease in demand for the rupee, and even though the RBI attempted to curtail the outflow through its $291 billion worth of forex reserves, they were unable to prevent the markdown. The capital outflow was stimulated by the signs of recovery in the US economy such as the declining unemployment rate and the unwinding of the Quantitative Easing package that had been in use since the end of the Great Recession. The depreciation caused a widening of Current Account deficit in India, as well as a withdrawal from the debt and equities markets. Additionally, in a time of sluggish growth (5 per cent in 2012-13), a depreciation reduced investor confidence in the ability of their Indian assets to produce adequate returns, and as these investors pulled their capital out, the Rupee depreciated further (according to an article on EconomicsDiscussion.net). Although the effects of sharp capital outflows chasing high returns in foreign markets can be a cause for concern, a depreciation in the near future is unlikely to be as extreme in its effects as it was in mid-2013, especially considering that Indian forex reserves might expand to $400 billion by September.
The Indian economy today is indeed in an interesting time, with no red lights flashing, but a finger hovering over a button waiting to slam down if any decisions from this point on are misguided or mistimed. Inflation is far below its target and thus a moderate increase should not be concerning; borrowing costs are quite high (as compared to those of India’s peers with the same level of per capita income) and credit growth is slow, so a reduction in rates in the short run is ideal. It should be noted that defaults are also quite high, and all observers have their sights on the levels of non-remittance for bonds and loans to state owned companies (source: Bloomberg). The rupee is slightly overvalued, and a depreciation would lead to inflationary pressure in the medium to long run, while helping exporters make up for losses caused by the recent import surge and take back ground from their competitors in countries like China, Sri Lanka, Vietnam and Bangladesh.
The appreciation has been on the backs of capital flows into the debt and equity markets. The onset of a depreciation may cause a loss of this capital, as may an increased confidence in US and European markets. Thus, in the short to medium run, the RBI should lower rates further so as to bring the Rupee down from an overvalued to a healthy level and to stimulate economic and credit growth. Given that the current run of the equities market is perhaps the healthiest bull market in the recent past (according to Money Control), a depreciation should not be accompanied by a precipitous outflow of capital from India. The probability of an outflow is further reduced by the relative strength of the Indian economy (as compared to 2013) and the declining trend in Current Account deficit (considering its expected marginal expansion). The Indian economy is strong at its fundamentals — a moderate and healthy correction to the Rupee, steady credit growth, and a prevention of steep capital outflows will help it continue on a robust growth path.
The author, Mihir Baxi, is an economic analyst and researcher. His work focuses on international economic affairs.
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