Introduction

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.

China

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.

India’s preparedness

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)

Conclusion

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)