In the past few months, there was a sense of unease in international economic circles that the high levels of current account imbalances could lead to competitive depreciation of currencies. The disquiet stems from an inchoate feeling that the probability of another economic downturn is rising. The tipping point could be one of several other imponderables, e.g. widespread home loan defaults, sovereign debt restructuring among countries on the European periphery. This article reviews the issues involved and suggests that India should anticipate and “hedge” against the growing risks to which it is exposed.
The steep slide in growth, after the financial meltdown in September 2008, was arrested and demand fostered through coordinated fiscal expansion in the G20 economies. More recently, several European countries, including the UK, have embarked on belt-tightening as they try to rein in fiscal deficits and reduce their stocks of sovereign debt. This has been accompanied by uneven efforts in the US and Europe to tighten financial sector regulation and accounting standards. The Basel III solvency and liquidity requirements are not adequate and implementation is stretched too far out till 2018. Although Europe is setting up an agency to monitor credit rating agencies, starting January 2011, there has been little coordination on this subject between the US and Europe.
On November 3, 2010, the US Federal Reserve announced that it had started on a second round of quantitative easing (QE2) amounting to $600 billion. In the first phase of quantitative easing, the Federal Reserve bought medium- to long-term US Treasury and mortgage-backed securities, mostly issued by Fannie Mae and Freddie Mac, and its balance sheet increased in size from $800 billion in September 2008 to $2.3 trillion in October 2010.
Countries such as Japan, Brazil, Thailand and South Korea had intervened in foreign exchange markets or raised barriers to capital inflows even before QE2. China, Germany, Japan and South Korea (current account-surplus countries) are likely to take steps to maintain their export competitiveness if the dollar were to depreciate significantly from current levels.
A number of economists, including one of the members of the Federal Reserve, have suggested that QE2 will not be effective since businesses and individuals are reducing their debt levels and even if medium- to long-term dollar interest rates come down, credit off-take will not increase commensurately. Clearly, there are structural issues in developed economies which need to be addressed directly. For example, shortfalls between unemployment/pension outflows and corresponding sources of revenues in some European countries, and the overweening primacy and distorted incentive structures of the financial sector in the US.
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The US has suggested that current account surpluses/deficits be capped/limited to 4 per cent of GDP. It is impossible to compress the differing causalities and challenges that the G20 economies face into one current account number. Consequently, there are differences on whether surplus or deficit countries should bear most of the burden of adjustment. Inevitably, the G20 summit meeting in Seoul on November 11-12 did not arrive at a consensus on current account imbalances. It is unfortunate that the spotlight was not on how best to improve upon and implement the Financial Stability Board’s mixed bag of recommendations on strengthening financial sector regulation.
As of November 2010, Treasury Inflation Protected Securities (TIPS), from short-dated to five-year maturities, were trading at negative interest rates. Apparently, investors in TIPS are convinced that the US is headed towards higher inflation levels and this could result in significantly higher commodity prices, including oil. The US has sailed into uncharted waters with QE2 and the risk that asset bubbles will spread globally has increased.
India runs a chronic trade deficit and for fiscal year 2010-11 the current account deficit could be around 3.5 per cent of GDP. In this context, it has been argued by many that the rupee is overvalued. Others maintain that infrastructure inadequacies are more to blame for India’s lack of export competitiveness and the rupee’s real effective exchange rate has not appreciated much against a basket of 36 currencies. Instead of a basket of currencies, it would be more accurate to track the rupee’s movements against the currencies of our principal export competitors on an item-by-item basis.
What are the implications for India? To an extent, the recent steep increase in Indian stock market valuations has been fuelled by low interest rates in the US, Japan and Europe. With the QE2-induced increase in dollar liquidity, additional forex inflows can be expected, beyond what is needed to meet our current account deficit, which would tend to push up the rupee and boost the carry trade in Indian stocks. Nominal Indian 10-year sovereign interest rates are about 6-7 per cent higher than comparable interest rates in the US, Europe and Japan. Forwards and futures markets in exchange rates are determined by nominal spot exchange rates and nominal interest rates, and based on interest rate parity, the nominal rupee should depreciate consistently against the dollar, yen or euro. In contrast, the nominal rupee has been appreciating over the last 12 months. It follows that India needs to “manage” the rupee exchange rate and we should hasten slowly towards capital account convertibility.
India is capital-deficient and should welcome foreign capital. Evidently, greater competition in the Indian financial services sector will enhance efficiency in credit intermediation and bring benefits to customers. Ideally, the caps on foreign direct investment (FDI) in the financial sector, including insurance, should be raised. However, we are not in a position to open up the financial sector much further without addressing the bottlenecks which prevent the absorption of forex inflows in real sectors. On balance, Indian banking should continue to be boring and capital markets stripped of irrational exuberance.
In response to slow growth and high levels of unemployment, the home countries of John Keynes and Milton Friedman have decided that one size does not fit all. Namely, the UK has decided to tighten fiscally while the US has taken the unorthodox QE2 route. This should convince the ideologically committed in India to be pragmatic and to promote FDI in real sectors while moderating access to relatively volatile portfolio inflows. We have to be alert to minimise the impact on India of what currently appears to be an inexorable march towards another financial sector crisis within the next five-to-seven years.
The author is India’s ambassador to the European Union, Belgium and Luxembourg. The views expressed are personal