Once again, emerging market currencies are falling but not nearly as dramatically as in May-August 2013. The episode was sparked by the US Fed indicating it would soon taper and eventually end quantitative easing (QE3). Tapering is now partly priced into markets, but a new problem is GDP slowing and a possible financial crash in China.
For years, the Fed has kept short term interest rates near zero, saying normal rates will return when unemployment falls to 6.5%. Last month, US unemployment unexpectedly fell to 6.7%. So, by the end of 2014, short-term rates may rise, and 10-year gilts could yield 4%. The prospect may induce periodic dollar outflows from emerging markets right through 2014.
What should India do? There is no need for panic. The RBI should let the rupee drift gradually towards Rs 65 per dollar by end-2014. Indian inflation is so much higher than global inflation that 5% depreciation per year is permissible, and probably inevitable.
In a recent paper titled Tapering Talk, economists Poonam Gupta and Barry Eichengreen examined exchange rates, stock prices and forex reserves in emerging markets between April and August 2013. Unsurprisingly, they found that the worst-hit countries had high current account deficits and appreciating exchange rates.
Surprisingly, however, good economic fundamentals like the budget deficit, public debt, forex reserves and GDP growth did not provide insulation against currency shocks.
What mattered far more was the size of a country’s financial markets and dependence on global portfolio investors, called FIIs in India. FIIs flows are desirable, but carry risks too.
Bric Wall Turns Fragile
The paper concluded, “Neither capital controls nor fiscal tightening, nor even a combination of the two, sufficed to damp down the effects of financial inflows. Instead, a broader array of macroprudential policies — limits on the rate of growth of bank lending, loan-to-value regulation for the mortgage market and similar measures — which moderate the upward pressure on the exchange rate and the widening of the current account deficit may have made a difference, and may, therefore, be called for in the future.” Other measures include lower deficits, higher reserves and hedging foreign loans.
These are all medium-term measures. What immediate measures are called for? Eichengreen and Gupta imply that emerging markets cannot do much in the short run. Defending currencies typically does not work.
Central banks can do what the RBI did last summer: try to limit exchange rate volatility and maintain liquidity while waiting for global portfolios to be rebalanced.
Financial markets no longer talk of Brics. Instead, they worry about the Fragile Five: Turkey, Indonesia, India, South Africa and Brazil. Does India really merit this label? It was unquestionably fragile last summer.
But since July, exports have risen substantially after two years of stagnation.
The current account deficit was a whopping 4.9% in the first half of 2013-14, but rising exports and import compression (mainly through gold controls) slashed this to 1.2% of GDP in the third quarter. This may not be sustainable, but the annual deficit is now projected at around 2.5% of GDP, which is sustainable. Exports did not grow when the rupee fell from Rs 45 to Rs 55 to the dollar.
But after the rupee fell further to Rs 62 per dollar, exports grew. This is an argument for the RBI to let the rupee to fall further, to maybe Rs 65 per dollar by the end of 2014. This would reflect the continuing inflation differential between India and other countries.
The RBI can intervene to check excessive volatility but must not aim for a strong rupee (which apparently Narendra Modi favours).
Global Demand Sensitivity
Some studies, such as that of Rangarajan and Mishra, suggest that Indian exports are not very sensitive to the exchange rate, and are far more sensitive to global demand. This implies that deliberately weakening the rupee is not good policy, and that exports will do well anyway in 2014 with the global economic revival.
But maintaining a constant real effective exchange rate means depreciating the nominal value.
5% Shrinkage is Fine
An op-ed in August 2013 by finance ministry consultants Malkani, Mishra and Mohunta projected the July 2013 rate (around Rs 59 per dollar) as a fair exchange rate. Actual experience showed that Rs 62 was more realistic.
And there is a case for currency depreciation of 5% per year if Indian inflation remains so high. Lessons? First, a rising global economy is cause for hope, but can be offset by bad news from China. Second, Eichengreen and Gupta have shown that the key issues are the current account deficit and unrealistic exchange rates. India has done well to bring down its current account deficit, and must continue to encourage exports.
Third, curbs on gold imports must continue through 2014, notwithstanding the inducement to gold smuggling. Fourth, while the RBI can intervene to check extreme volatility, it should not defend the current value of the rupee. Depreciation up to Rs 65 to the dollar by end-2014 is acceptable.