Making the most of a mini-crisis
It all looked promising at the beginning of the year: the Indian rupee, like other Asia ex-Japan currencies, was appreciating against the dollar, to an extent on par with the Chinese yuan and just behind the Thai baht and Malaysian ringgit. Then came chatter in early May that the Federal Reserve was near gradually ending its money-printing program. The selloff in the rupee was rapid, and the currency lost more value than most of its Asian peers.
On Wednesday, Federal Reserve Chairman Ben Bernanke said the central bank will begin slowing the pace of its bond-buying stimulus later this year, triggering a global selloff that sent the rupee crashing to a record low on Thursday morning.
So how can the rupee recover? The quickest way is for the Reserve Bank of India (RBI) to use its dollar reserves to buy the rupee from the market, thereby stabilizing the currency. Some think the RBI can afford to do so because its foreign reserves are now equivalent to 15 percent of GDP, almost double the level in 1998. Then again, most other Asian countries have larger buffers, which renders the rupee more vulnerable than most of its Asian peers in case of future episodes of capital flight. In other words, supporting the rupee with reserves can only be short-lived and is a sure way of depleting India of international currency.
The key to solving the issue is reviving investment. One way to achieve this is for the RBI to cut interest rates further. It certainly has room to do so: both economic growth and the inflation rate are below 5 percent. Of course, the near-term casualty will be the rupee itself. Part of the currency’s attraction is the high interest rates in India than in the United States, so lower domestic rates would mean less attraction to buy the rupee, and a lower rupee would then mean higher inflation due to higher import costs. Already, the currency’s weakness has cancelled out the benefits of falling oil and gold prices in dollar terms. However, lower rates would stimulate investment in the real economy, as it would mean lower borrowing costs for companies.
India had already caught attention when the government removed some barriers to foreign direct investment. Encouragingly, the pressure on the rupee has renewed the government’s attempts to maintain this interest, even though it could do more. Besides unclogging project bottlenecks with the Cabinet Committee on Investment, which has already shown some success, it could introduce more market-oriented pricing of coal and gas. This would make new projects more economical for investors, and seems to be a goal within reach. Further improvements in foreign direct and portfolio investments would also help.
Policymakers could do worse than act now to prevent the mini-crisis from becoming a real one. Despite what the charts say – that the rupee is at an all-time low against the dollar – the currency’s weakness is not yet a precursor to a major crisis. However, it is incumbent upon government to acknowledge the signs and prevent the problem from growing to more damaging proportions. The remedy is no secret.
No one harbours the illusion that India will be able to swing its current account balance from deficit to surplus and thus lift the rupee. In fact, this is not even necessary. All it takes is to follow up on the measures that instil investor confidence as described above. Given these, foreigners will be just as happy to finance India’s financial shortfalls as they did in 2012, when the rupee depreciated only mildly despite a record current account deficit, allowing the RBI to keep its foreign currency powder dry.
Assuming the government enacts measures to boost investor confidence, we can see the rupee recovering to 55 per dollar by year-end, which could then mean that the currency will not stand out against its Asian peers for the wrong reasons.
By Hartmut Issel