The Currency Risk
India's macroeconomic parameters are sliding at a time when the world is staring at a full-blown trade and currency war.
Acurrency war, fought by one country through competitive devaluations of its currency against others, is one of the most destructive and feared outcomes in international economics.. whether prolonged or acute, these and other currency crises are associated with stagnation, inflation, austerity, financial panic and other painful outcomes. Nothing positive ever comes from a currency war." - Excerpted from the book Currency Wars: The Making Of The Next Global Crises by James Rickards.
Three years after the global financial meltdown of 2008, investment banker James Rickards penned his book on the new battleground of future wars amongst the economic superpowers. It was not nuclear or chemical, but financial war. His subject future 'Currency Wars' is very apt in today's context. The world actually fears one between the two economic superpowers.
Rickards linked the currency wars as a subject of national importance and security and not just a subject of discussion for economists and investors. Call it political compulsions, or ground reality, US President Donald Trump has been accusing its trading partners - especially China and the European Union - of artificially depreciating their currency to render their goods more attractive in the US.
Recent trade tariffs by the US in steel and aluminium has seen China react with similar levies on US exports. Both are preparing their next lists to fire at each other. The trade war is already turning into a currency war where Chinese currency saw a sharp depreciation of around 8 per cent. This may be a Chinese tactic to neutralise the impact of higher tariffs for its exported goods in US with a depreciated currency. "Chinese currency is dropping like a rock," said Trump, advocating a weak dollar to gain competitiveness. Has the currency war already begun?
"We are possibly at the beginning of a currency war," said Urjit Patel, Governor of the Reserve Bank of India, as he recently released the monetary policy. "It looks like it will continue, but we don't know for how long," he said expressing concern on the implications of a trade and currency war for India's economy.
The RBI will face a serious dilemma should currencies of other emerging market drop big time. Should India join the competitive devaluation game to protect exports or stay away to boost foreign investors' confidence? Experts say the RBI will not welcome depreciation or high volatility in the Rupee's value against the US dollar. But if the rupee value slips beyond a point (say, beyond 70 or 72) in a very short period, it will need to consult the government. In the past, the finance ministry has announced steps like higher import duties on gold imports.
There are actually no winners in currency wars. In a US-China standoff, there are expectations of flight of capital, especially dollars, from Chinese equities and debt; and, the fear of competitive devaluation by other countries to neutralise Chinese devaluation. In a competitive devaluation scenario, India will not be a pariah.
The threat from the trade and currency wars is real. In emerging markets including India, mounting trade tensions, higher crude oil prices, and hardening of interest rates in US has already created an uncertain environment. The immediate reaction can be seen in global financial markets - US rates are rising and the dollar is strengthening. The EU is likely to hike interest rates from 2019 and collateral damage will be in emerging markets.
Currencies in emerging market are sliding down. This year, the biggest losers are the Argentine Peso, the Turkish Lira, the Russian Rouble, the Indonesian Rupiah and the Filipino Peso. The Indian Rupee's fall of close to 8 per cent against the US dollar is in line with this trend. Indian currency is now being clubbed with a few other emerging markets as 'vulnerable. "We remain bearish on the Indian Rupee, the Indonesian Rupiah and the Filipino Peso - all three economies with twin deficit problems," says a Scotiabank report (see graph Sharp Fall In Rupee in 2018).
India's Twin Deficit Problem
India has been living with the 'twin deficit' problem for decades. Historically we run a trade deficit despite numerous efforts (the latest was Make in India) to increase exports. China leapfrogged to become the world's export factory in the last few decades, but India's trade deficit widened. In 2017/18, it increased to $156 billion from $108 billion in the previous year. Growing imports are also hurting the trade deficit. Surprisingly, imports of 'electronics' are growing fast, with billions of Indians consuming all sorts of gadgets. "We failed to grasp or promote key industries such as electronics," a banker said.
Salil Datar, CEO and Executive Director, Essel Finance, blames the large oil component in the import basket. "Rising oil prices are increasing the import bill," he says. There is also new danger after US sanctions on Iran that begin this November. Iran is one of the three big suppliers of oil to India. "Financing trade deficit is a big concern," says a forex dealer. Ever-increasing trade deficits need dollar inflows in equity, debt, and FDI to bridge the gap. While institutional inflows in debt and equity are classified as 'hot inflows' - they come and go in quick succession) - FDI inflows are more permanent. Currently, India's current account deficit (CAD) has jumped from 0.6 per cent of GDP in 2015/16 to close to 2 per cent in 2017/18. Going forward, higher valuations will mean difficulty in attracting equity market inflows. After touching a net inflow of Rs 1.11 lakh crore in 2014/15, equity inflows are not very encouraging. In the first four months of 2018/19, net equity inflows were in the negative of Rs17,276 crore. The debt market saw robust inflows last year at Rs1.18 lakh crore, but the uncertain Indian market and the higher yields in the US make things tough. FDI equity numbers though are keeping the pace with close to Rs3 lakh crore last year, but are still nowhere close to China's figures.
The outlook for the rupee looks weak but it isn't as bad as September 2013 when it was dropping like a rock. India was among the fragile five then with South Korea, Brazil, Indonesia, and Turkey. Macros, especially inflation, current account balance and foreign exchange reserves are relatively better now. Global investment banker UBS expects the rupee to be in the range of 68-72 against the US dollar in the short term. The RBI is already protecting the rupee from falling 69 levels. The signs of RBI intervention are quite visible as foreign exchange reserves have fallen from a high of $425 billion in April-May to $400 billion. Meanwhile, the market is watching how long the RBI protects the rupee, given the cost of intervention. A large section of stakeholders have advocated gradual depreciation of the rupee to improve export competitiveness. Raghuram Rajan, former RBI Governor, (rightly) argued in the past for the need to improve productivity to remain competitive. He also linked productivity gains to better infrastructure facilities, improved human capital, removing administrative obstacles and ease of doing business.
Moreover, higher interest rates help battle currency depreciation but arent advisable. The RBI's decision to hike the repo rate by 25 per cent will help. Its primary worry will be the 'currency wars' and how to contain the likely spill-over impact on the Indian Rupee. If the currency weakens, it plays havoc with investments, inflation, interest rates, and what not.
Central bankers must also remember what Rickards wrote in his book, "a new collapse, larger than the one in 2008, not just a possibility, but a certainty". Time to tighten the belt.