The macro-economic news in India hasn’t been all that bad lately. Inflation, though still high, is showing some signs of easing off, helped by softening commodity prices. GDP growth during the first quarter was not too shabby at 7.9 per cent, while the industrial production numbers for July came in with a respectable growth rate of 7.1 per cent. The equity markets, while still way below their highs achieved earlier, were proving to be range-bound, suggesting that a floor had been found below which the market would not fall because value buyers would surface.
Then came the Lehman Brothers bombshell, signalling to markets that there were to be no more rescues and bail-outs, however large and prestigious the institution. The response by Indian markets was entirely predictable; sharp declines in the benchmark indices in early trading, accompanied by depreciation of the rupee, as foreign investors sought to exit both the market and the country. The sizeable presence of foreign portfolio investors in the equity market means that they cannot escape the consequences of developments of the kind exemplified by the Lehman Brothers bankruptcy. But, these are matters for future debate; the immediate task is to quickly assess the vulnerability of the Indian economy to the events of the week-end and to take the steps necessary to minimise the fall-out. On the face of it, the evidence would suggest that the risk to the real economy is quite small at the moment.
Even in the markets, there was some re-assurance as the day unfolded. The benchmark indices recovered somewhat from the morning’s collapse to finish about 3.5 per cent below Friday’s close. The rupee, which had fallen below the Rs 46/$ mark in early trade, also recovered to end just above that mark. The recovery indicates that, at least as far as India is concerned, investors have not entirely lost sight of the good opportunities that still exist in the market. However, no one can count on this confidence persisting in the face of further bad news from the US and other markets. The outlook for equity markets in the immediate future is necessarily negative; correspondingly, the outlook on the rupee also points towards further depreciation against the US dollar.
The movement of the exchange rate poses the immediate challenge to the Reserve Bank of India and its fellow central banks in emerging markets. A couple of years ago, their efforts to resist appreciation enhanced the attractiveness of these markets to investors, as this suggested a currency upside on top of the stock market pay-off. Money poured in, but the reverse is in effect now. As the currency depreciates, foreign investors have the incentive to take their money out before the rupee depreciates further and erodes their returns. This incentive may overwhelm any other reason for them to stay invested in the country. In this situation, central banks can do one of two things: firmly resist depreciation by drawing down on their foreign exchange reserves, which are substantial for most of the countries in the region; or, completely disengage from the process, letting the exchange rate move very quickly to a sustainable level so that the macro-economic fundamentals regain influence over investment decisions. Both approaches carry risks. A creeping depreciation could feed investor uncertainties and hasten exit, whereas a sudden drop in currency value could precipitate a further downside if the market loses confidence. Policy-makers will be on test.
