The past week has been a harbinger of turbulence in emerging market currencies. The Argentinean peso fell by over sixteen percent in official value against the US dollar. This has been the steepest ever since Argentina had defaulted on its debt in 2002.This triggered an erosion of confidence in other emerging markets. The Turkish Lira plummeted to record lows, and the South African rand too weakened. Two external macroeconomic linkages that were responsible for weakening of currencies are the uncertainty of Fed tapering, and concerns about global growth in general and China in particular. In comparison the Indian Rupee has not been affected as severely due to the proactive stance of the policy makers.
The recent PMI data which is recorded below fifty indicates economic contraction due to slowdown of manufacturing sector in the Chinese economy. The decision of China to shift from investment led growth to consumption led growth over a period of time too would have a global impact. The fastest growing economy in the world has had a massive appetite for commodities, and has seen fastest growth in imports from the commodity complex’ of metals and energy in the past decades. These commodities were funneled into its infrastructure and manufacturing sector. This was financed by underpriced massive loans from its state run banking sector, leading to huge accumulation of debt. The export growth rates of China on account of slowing of USA and Europe after 2008 crisis have been declining. In addition its increasing debt overhang has forced its policy makers to veer their gigantic economy towards consumption led growth .The commodity exporting emerging nations have seen a fall off in their exports, especially to China. Current Account deficits are widening putting a pressure on their currency fuelling inflationary pressures. All this series of events are coinciding with Fed tapering of QE3.
Federal Reserve Tapering
On May 22nd, 2013 that the word ‘taper’ entered the lexicon of capital markets when the Federal Reserve chairman Mr. Bernanke first broached the possibility of tapering QE3 (Quantitative Easing, 3rd Tranche). Markets across the world panicked, emerging economies struggling with unsustainable current account deficits were the hardest hit. Indian rupee for instance fell from Rs. 54 to the dollar to nearly Rs. 68 against the dollar. This negatively impacted equity and bond markets as foreign investors with ETF allocations fled. Bond markets saw the sharpest outflows. The panic reaction from markets sobered the Fed. The Fed in its wisdom in a surprise move, decided to postpone the taper in September, without outlining a time frame. Consequently markets rebounded and rose to touch historically highs by December across the world. It seemed the markets had forgotten that this was just a temporary measure. However as the US economy continued to gather steam and a budget balancing deal was struck. Any uncertainty surrounding the fiscal and monetary framework got removed. The positive momentum of US economy prompted the Fed to announce a 10 billion dollar taper in QE 3 program in January 2014.
In May 2013, after Fed indicated the possibility of tapering , India was in dire straits. The three pressure points that emerged were the unsustainable current account deficit (which had risen to 4.8% of GDP); the possibility of a ratings downgrade by international credit rating agencies to junk; and lack of adequate foreign exchange reserves to fight a speculative attack on the rupee. The finance minister vowed to maintain the path of fiscal consolidation and bring down the fiscal deficit to below 5% of GDP. Various cuts in plan and non-plan expenditure have been instituted It was around the same time that a change of guard was happening in the RBI. The new incoming RBI governor, with the finance minister rolled out several measures to setup a bulwark against these pressure points.
RBI instituted several measures to protect the currency, these were
· Current Account Deficit Management
Oil and gold were the main factors causing the ballooning deficits. Import duties on gold were hiked, and later a proportion of the quantity of imports were tied to exports. Petrol prices were decontrolled fully and diesel partially to partially pass on international prices to the domestic consumer, thereby lessening subsidies, and allowing elasticity to play a part in controlling consumption. This led to improvement in CAD as can be seen in graph 1. In 2012-13 it stood at 4.8% of GDP but after the measures fell to 1.2% of GDP
Graph 1: India’s Current Account Deficit as a Percentage of GDP
· Shoring up of Forex Reserves
Limits on foreign borrowings were eased for corporate as a start, then, the RBI came out with a program to bring in dollars through the FCNR (Foreign Currency Non Resident) route. Banks were encouraged to raise hard currency deposits, and the RBI subsidized the hedging costs of these deposits at 3.5%, whereas the market prevailing rate was double that. Limits on FII investment in rupee debt were also liberalized.
· Curtailing speculation
RBI squeezed liquidity in the domestic market to prevent easy liquidity from being leveraged to speculate on the forex markets. Short term interest rates were hike by 300% at the MSF (Marginal Standing Facility). Quantitative limits were placed on banks borrowing at the repo level. These steps stemmed the outflow of foreign currency, bolstered our own reserves, and instilled some confidence in foreigners on their India investments. The FCNR swap itself brought in 34 billion US Dollars into the country. The danger of rating down grade too was averted by promise of continued reduction in fiscal deficits, further easing of bond investment limits among several others . Due to these measures, and the Fed’s decision to postpone tapering, confidence in India rebounded. FII investments came in, and the rupee rebounded. Today, India’s foreign exchange reserves are comfortable. As can be seen in graph 2 , Foreign Exchange reserves which had started dipping after FED announcement started bolstering up.
Graph 2: Indian Foreign exchange Reserves ( US billion dollars)
It seemed markets became too sanguine about having factored in the Fed tapering. Last Wednesday, when the Argentina’s currency crisis exploded and spread the contagion to other countries, the markets became jittery. The Indian rupee, in contrast stood at 62.66 against the U.S. Dollar. The laudatory efforts of our new RBI governor to bolster the economic defenses against the depreciating currency in 2013 need to be acknowledged. It has been because of these efforts that India has been comparatively less affected till date. It might hence be construed and hoped that India will not be dramatically affected by the current currency crisis enveloping the emerging nations.
Contributed by Prof. Sarika Rachuri (Faculty, IBS Mumbai)