Prospects of a Modi election victory have induced a dollar flood into Indian bonds and equities. The rupee has strengthened to below Rs 60 per dollar.
If the strong rupee was caused by an export boom, everyone would be delighted. In fact, it has been caused by hot money plunging into the speculative froth of a Modi victory. This sort of strong rupee torpedoes India’s export prospects without providing any sustainable gains.
Some investment banks see the rupee strengthening further to Rs 58 per dollar. Adam Gilmour of Citigroup says it could strengthen to Rs 40-45 per dollar if Modi wins handsomely. But this would be disastrous for India’s competitiveness and balance of payments. The RBI must send a clear signal to forex markets that it will keep the rupee competitive. It must mop up excessive inflows. The consequent increase in rupee money supply should be sterilised by equivalent RBI sales of gilts, checking any inflationary impact.
Many ordinary Indians feel good about a strong rupee. But equating national prestige with a strong rupee is wrong. What matters is that India’s exports are competitive, and current account deficit under control. If this co-exists with a strong rupee, fine. But if this requires a weaker rupee, that’s fine too. The exchange rate is a means to an end, not an end in itself.
Last year, Prachi Mishra, Rohini Malkani and others in the finance ministry calculated that a reasonable exchange rate might be Rs 58-60 to the dollar. All such calculations are iffy, but many foreign analysts had a similar view. However, the continuing inflation differential between India and the world means that the same model will indicate a reasonable range of Rs 60-62 per dollar today. Inflation is falling but remains well above rates abroad, so a competitive exchange rate might be Rs 63-65 per dollar by the end of 2014.
The composition of the recent dollar inflow is dismaying. Of the $8-billion inflow since January, no less than $6 billion is into gilts. Indian interest rates are sky-high by global standards, with short-term gilts yielding 8.5%. Last year, rupee depreciation made the high rupee yield illusory.
But today, foreigners get a high coupon plus currency appreciation, giving a fabulous total return of maybe 10%. No wonder they are flooding in. It’s wrong to finance India’s current account deficit by borrowing short term at an effective dollar rate of 10%. The RBI must discourage debt inflows of less than two years’ duration. The interest rate for two-year gilts is just a fraction more than for three-month treasuries, but carries a clear exchange rate risk — the rupee will very probably depreciate in two years. Three-month inflows constitute risky hot money, which will flood out if the election results don’t meet expectations. Two-year inflows will be much less volatile.
History has repeatedly shown India’s vulnerability to sudden stops of forex inflows. Such sudden stops can be triggered by global events even if there is no disaster in India itself. The best remedy is continuously rising productivity, making exports more competitive and imports less competitive, ending any significant current account deficit.
In less ideal conditions, safety can be improved in two ways. One, limit the current account deficit by letting the rupee depreciate when exports turn uncompetitive. Two, encourage relatively stable dollar inflows, and discourage relatively unstable ones. There are four sorts of forex inflows. The most stable, desirable sort is foreign direct investment (FDI). Foreign-owned factories and power stations cannot exit in a panic.
No Running Away
The second most stable inflow is into equities. If foreign investors try to exit en masse in a panic, stock prices and the exchange rate plummet. Equity investors can exit only at a very steep loss, so many stay put. This was demonstrated in the Asian Financial Crisis and Great Recession. The third most stable — or second most unstable — inflow is into medium-or long-term rupee bonds. Here too, any mass exit will depress the price and exchange rate too. But bonds are far less volatile than stocks, and so carry a much lower exit penalty.
The fourth, worst sort of inflow is dollar-denominated debt, which on maturity is repaid in full without any exit penalty. Long-term dollar debt takes time to mature, and is not so hot. But short-term dollar debt matures very quickly and is the hottest-ofhot flows. Rupee-denominated short term debt is not quite so bad, since it carries some currency risks (which are, however, limited because of the short maturity).
These facts should guide the strategy of the next government and of the RBI. Priority should be given to raising productivity and, thus, reducing the current account deficit. As for inflows, FDI is the best. Inflows into equities is also desirable. Dollardenominated debt should not be encouraged. And foreign investment in short-term debt, whether in rupees or dollars, must be strongly discouraged. Hot money must not be allowed to make exports uncompetitive.