The recent turmoil in emerging markets following the US Fed’s decision to go ahead with a gradual reduction of its asset purchase program, also known as the Quantitative Easing (QE), is a stark reminder of their underlying vulnerability.
Although almost every emerging economy was hit, a few are deemed to be most susceptible. These countries also referred to as the “Fragile Five†includes Brazil, Indonesia, Turkey, South Africa and unsurprisingly, India. All of them suffer from the same malaise – deteriorating fiscal balances, lack of political will to implement the next generation structural reforms, perilous external balances that would be difficult to fund in an environment of low liquidity due to Fed scaling back and political uncertainty in form of elections.
Repeat of 2013 for rupee?
The situation is eerily similar to July last year when following an indication of tapering (scaling back the asset purchase program) by the sitting chairman of Federal Reserve, Dr. Ben Bernanke, all emerging market currencies, particularly the Indian rupee, went into a tailspin. Despite aggressive tightening by RBI (Reserve Bank of India) and a host of other measures, the rupee was the worst performing emerging market currency in 2013.
However, this year the rupee has witnessed a reversal in its fortunes and has remained stable despite the headwinds coming from the US Fed. This begs the question as to what has changed since the slide last year and whether the rupee would continue to outperform its emerging markets peers going ahead.
The biggest concern from the currency perspective in India was the gaping current account deficit (CAD) which came at 4.80% of the GDP for the FY 2013 and was expected to further widen in the following year. Most of the rise in CAD was attributed to a jump in gold imports which itself was a result of the negative real returns in India (due to persistently high inflation) that caused the savers to move away from financial savings towards physical savings in form of gold. Following Dr. Bernanke’s statement regarding tapering markets starting wondering whether India would be able to fund its CAD through capital flows in an environment where liquidity was scarce and this led to the sharp depreciation of the currency. The RBI followed up with a knee jerk reaction of raising short term rates and failed spectacularly.
Things began to change with the arrival of the new RBI governor, Raghuram Rajan. In his first press conference he hit the right chords by talking about combating inflation, financial inclusion and greater competition in the banking sector. He followed it up by taking dollar demand of oil companies out of the market by opening a swap facility at RBI and at the same time boosted capital flows by incentivising banks to raise dollar deposits (FCNR deposits) from abroad. This proved to be a master stroke and the confidence in the currency was restored.
Rupee Outlook
Looking ahead, the rupee is expected to avoid a repeat of 2013 and stay stable this year because of the following reasons –
1) The current account deficit has been reined in primarily due to the sharp compression in gold imports and a recovery in exports (CAD for the FY2014 is expected to be around $30 bn or 2.50% of the GDP). It is expected to stay low during the next financial year barring a sudden upsurge in growth (highly unlikely given the expected sharp cuts in capital expenditure last year and this year to meet the fiscal deficit target) or gold imports (though expected to increase once the duties are brought down, the pick-up is unlikely to be extreme enough to jeopardise CAD).
2) On the capital flows side, after being net sellers in the Indian capital markets last year, the FIIs have returned as net buyers of rupee denominated bonds and Indian equities. Given the vast improved situation on the external front, the flows are expected to remain healthy enough to finance the CAD during this year.
3) The FX swap deal (worth $50 bn) between RBI and Bank of Japan along with the measures to internationalise the rupee (issuance of a rupee denominated bond by IFC and inclusion into bond indices which will increase the foreign holding of the rupee denominated bonds) should prop up investor sentiments regarding the currency.
4) The foreign exchange reserves with RBI are comfortably placed at $293 bn (thanks to the FCNR deposits raised by the banks) providing it with ample ammunition should a need to protect the rupee arise.
Risk Factors
However, before we turn too sanguine about the situation, it is important to note a few caveats. The political outcome of the national election to be held in May is one of the most important known unknowns for the rupee outlook. A positive outcome in form of a stable government at the centre will result in sturdy inflows and improved sentiments regarding the rupee while a negative outcome in form of a hung parliament is likely to hurt the rupee.
Apart from this a faster than expected tapering by the US Fed and a rating downgrade following a negative election outcome are some of the other factors that are negative for the Indian currency.
(The author is an IIM-Ahmedabad graduate, and an expert in financial matters)