<b>A V Rajwade:</b> Valuing the rupee

The huge deficit may lead to a reappraisal of India's macro-risk - this will change the rupee view

The huge deficit may lead to a reappraisal of India's macro-risk - this will change the view on the rupee.

The uncertainties about the interest and exchange rate outlook have increased after the Budget. Take the question of interest rates first. The budgeted borrowing program is of the order of Rs 360,000 crore. It has also been indicated that the outlays could go up by 0.5 to 1 per cent of GDP. Thus, the central government’s own gross borrowings would be of the order of Rs 400,000 crore. One would need to add to that the state government borrowings.

As against the gross borrowings, loans aggregating Rs 50,000 crore would be redeemed in fiscal 2009-10. It is also possible that the outstanding Market Stabilisation Scheme (MSS) borrowings of the order of Rs 100,000 crore may be converted into normal, fiscal deficit-financing loans: In other words, the unused funds lying to the credit of the central government, being proceeds of MSS borrowings, could be released for use. Adjusted for this, the central and state governments together may need to raise a net amount of Rs 300,000 crore from the market, even assuming that there are no off-balance sheet bonds, or under-provision of subsidies, as in the current year. Clearly, government borrowings would be a major drag on the resources of the banking system available for commercial credit, constraining the system’s ability to act counter-cyclically at a time of economic slowdown.

Apart from government borrowings, the demand for bank credit will also be high because:

 

 

With market in the doldrums, equity financing may shift to debt; 
 

Paucity of external funding too would increase the demand for rupee credit; and 
 

RBI sales of dollars would also suck liquidity from the market (see below).

Overall, if interest rates are not to harden, the fiscal deficit would need to be monetised, one way or another. (This cannot be done directly now.) And, the authorities can afford to maintain a relatively benign attitude towards monetisation because, with the global economy in a recession, inflation is hardly like to rear its ugly head up. To be sure, the trillions of dollars pumped into the system by the central banks and governments, would start impacting the price level at some stage.

The sad part of the scenario is that the government’s fiscal resources are under such strain, despite four years of 9 per cent GDP growth, and sharply increased revenues, both in absolute terms as well as a percentage of nominal GDP. (Contrast our fiscal stimuli with China’s $600 billion over two years!) The Prime Minister has, on dozens of occasions and different forums, argued that the current level of subsidies is unsustainable and that subsidies to the non-poor would need to be curtailed significantly if resources are to be made available for investment in areas like infrastructure, education, healthcare etc. But he has obviously been powerless to do anything about this during his stewardship of the country. Assuming that the UPA comes back to power, would he be able to do anything more concrete on the issue? Keep your fingers crossed.

The exchange rate
I was looking for a possible appreciation of the rupee in the second half of the fiscal with resumption of capital flows. However, the double digit fiscal deficit (central, states, and off-balance sheet taken together) may well lead to a reappraisal of not only our sovereign credit rating, but also the perception of the macro-economic risk in the minds of lenders/investors. Uncertainties regarding the post-election government and its policies may also foster a “wait and see” attitude. There is of course one positive sign: Equity prices have become much more attractive — on their own, as also in Asian comparisons.

Quite apart from such India-specific issues, we also need to keep in mind a few other factors:

The surprising strength of the dollar in the global market, despite a weak economy and the banking system in a mess. Perhaps, Europe is perceived even weaker on both the grounds, partly as a result of European banks’ exposure to countries in east Europe, whose currencies have plummeted in recent months. 
 

The Japanese banking system is probably strongest among the Big Three, but economic output fell at 12 per cent per annum in the last quarter of 2008. The yen rate has crossed 94. 
 

The possibility of banks with capital under pressure becoming risk-averse, focusing on domestic assets and shunning cross border loans.

(Incidentally, in the 1990s, a premature liberalisation of the capital account contributed to crises in several economies in east Asia. The current problems in the global financial market seem to have hit European countries more severely. Iceland was the first domino to fall and had to go to the IMF. It may be followed by several countries in east Europe (Poland, Rumania, Hungary, the Czech Republic and Ukraine) who may need the support of either the IMF or the European Union.)

Overall, the possibility of resumption of capital flows could well be delayed more than what one earlier thought, prompting further dollar sales by RBI.

avrajwade@gmail.com