First, the good news. A stable US economy, with signs of accelerating growth, will obviously expand market opportunities for exporters to the US significantly. India, for example, stands to benefit from both an expansion in business investment, much of which has a significant technology component, through software linkages and consumer spending, through sectors like gems and jewellery, garments and footwear. The value of the rupee today offers, in the short run at least, a competitive edge to Indian exporters, helping them to capitalise on the strengthening US economy. In turn, as the trade deficit narrows in response to this, India's vulnerability to reduced global liquidity levels decreases sharply, as recent events have vividly demonstrated. The sharp decline in the current account deficit is the most important reason why the rupee stabilised, even as the Fed initiated its taper in December. Improved prospects for currency stability will actually increase capital flows into India, even as global flows may moderate, because there will be a reallocation of portfolios towards less risky destinations.
But there are risks as well. The rupee's recent stability cannot be taken for granted just yet. The critical unknown is the outcome of the elections. It appears that a lot of funds have come into India in recent weeks based on the likelihood of a stable and business-friendly coalition forming the next government. This money will flow out just as quickly if that does not materialise. Even if it does, its first statements and actions will be watched very closely. A disappointing Budget, for example, will make investors nervous because of the increased likelihood of a sovereign rating downgrade somewhere down the line. Just as there is a virtuous circle scenario, there is a vicious circle one as well, with capital flight leading to sharp depreciation and vice versa in a self-fulfilling spiral. If this were to materialise, the acceleration of the taper by the Fed would only reinforce the pressure.
The message that comes from this and bears repeating is that the policy establishment needs to both act to prevent the vicious circle from materalising and be prepared to manage it if it does. For the former, quick and credible steps to address the structural factors that caused the current account deficit to balloon must be taken. As regards the latter, the Reserve Bank of India, notwithstanding its commitment to a floating exchange rate in normal circumstances, should shore up its reserves by buying up some of the possibly temporary inflows. In a still turbulent environment, more insurance is always better than less.