India needs to be prepared as much for a surge of capital inflows as a shortage
At the beginning of each year, members of our tiny community of market economists and forecasters take a hard look at their spreadsheets, stroke their chins purposefully and conclude that the rupee will appreciate quite considerably over the year. Since 2007, their forecasts have, by the middle of the year, proved spectacularly wrong. This, of course, causes extreme angst and embarrassment and is usually followed by radical changes in forecasts and desperate (and usually futile) attempts at damage-control. In short, our community’s credibility lies in tatters.
The reason for this consistent lack of success in predicting the fortunes of the currency stems from a somewhat persistent strain of the “India Shining” virus. Its most visible manifestation is the unshakeable belief that come what may, capital flows into India will be large and leave in its trail a hefty surplus of dollars that would, by the simple laws of arithmetic, translate into rupee appreciation. The financial crisis of 2007-08 was the first to blow a hole in this assumption. The lingering aversion to risk that came in its wake has also meant that despite apparently better “fundamentals”, capital flows into India have been tardy in the years that followed. In 2006-07, the capital account surplus over the current account (the excess supply of dollars) was over $90 billion. This year, 2010-11, we will be lucky to get a surplus of $5 billion. That is, we should, on average, be left with an almost negligible surplus of about $500 million every month.
An associated symptom of this malaise is a tendency to overlook the current account deficit, the draft on capital flows that our persistent trade deficit entails. In 2008-09, the current account deficit was $38.4 billion. In 2009-10, it is likely to be in the range $42-45 billion. When forecasters tend to treat the rupee as part of a larger Asian pack and try and link the Indian currency’s fortunes with that of the Asian basket, they tend to forget that most of our Asian peers either run current account surpluses or have relatively minuscule deficits. The data (see table) provide a hard reality check. In the April-August period, the Asian pack appreciated by 4.1 per cent. The rupee with its burden of the current account deficit has remained virtually flat. This despite the fact that portfolio flows into India have been higher than its Asian peers over the past few months.
There are implications that go beyond the narrow domain of currency markets. For one, the fact that capital inflows have been barely adequate to cover the charge on the current account is straining domestic liquidity. Excess dollars when purchased by the central bank lead to a release of rupees. With these flows falling short of expectations, RBI hasn’t had much of an opportunity to buy dollars — the result has been a “core liquidity” shortage that is beginning to affect the banking system. The data on money supply illustrate this clearly — M3 growth is currently running at less than 15 per cent. A comfortable growth rate to support 8.5 per cent GDP growth rate and target 5 per cent inflation, going by a simple monetary targeting rule, should be close to 17 per cent, which is the level that is officially targeted by the central bank. To press the point further, monetary growth is running behind its target by a whopping 2 percentage points. Incidentally, some bank treasury managers anticipate the possibility of a resource crunch by the end of the year if credit demand does pick up. I suspect that a number of the liquidity projections made at the beginning of the year were based on a scenario where capital flows would be abundant. The risk of a sharp escalation in deposit and lending rates seems real.
What is the solution then? The first step is to recognise the problem. Both currency and liquidity forecasters (including RBI) need to jettison the “default” assumption that there will be an embarrassment of riches as far as external capital flows are concerned. While there is a chance that they will revive, there is strong probability that a decelerating global economy will put a lid on risk appetite and harness capital inflows. It is also important to recognise the fact that funding the current account deficit is going to be a problem and that is impinging on domestic liquidity. Thus, while it is important to have a contingent strategy in place to handle excess capital inflows, it is just as important to have a policy-mix in place to handle a capital shortage.
| PERFORMANCE OF MAJOR CURRENCY BLOCKS AGAINST THE USD IN 2010 | ||||
| (In %) | YTD | 6mths | 1mth | 1 week |
| Asia ex Japan | 4.1 | 2.8 | 0.8 | 0.0 |
| INR | -0.1 | -0.8 | 0.6 | 0.3 |
| EUR & GBP | -7.3 | -2.4 | -0.4 | -0.4 |
| Commodity currencies | -1.2 | 1.1 | -1.4 | 0.1 |
| Note: The data are updated up to August 23, 2010 AXJ basket includes: SGD, KRW, IDR, THB, MYR & PHP Commodity currencies include the AUD and NZD Source: Reuters & HDFC Bank | ||||
What should be the elements of this mix? RBI could perhaps make a start by hiking rates on NRI deposit schemes. Attractive interest rates have been known to push up these deposits and there’s no reason why this won’t work again. The bond market provides attractive arbitrage opportunities given the obvious arbitrage window that low interest rates in the global markets open. It is perhaps time to raise the portfolio investment limits on both corporate and sovereign bonds. The central bank could simultaneously consider diluting some of the extant restrictions on external borrowings. If the capital shortage persists, there could be more radical policy measures — a programme on the lines of the India Millennium Deposit (IMD) scheme might seem a little aggressive at this stage but could be the policy of last resort. Finally, ramifications of the capital shortage are more acute for domestic liquidity than for exchange rates (some would argue that a weak currency actually helps). If the liquidity problem gets out of hand, RBI might consider slashing the cash reserve ratio by the end of the year when inflation pressures dissipate. What we need in these volatile times is a nimble central bank and not one that remains married to its stance.
The author is chief economist, HDFC Bank. The views expressed are personal