Is the tide finally turning? After the slew of bad news and disappointments in 2011, a marked sense of optimism has enveloped markets in 2012. Equity markets have rallied sharply this year and, after prolonged weakness, the rupee has bounced-back a staggering seven per cent over the last month.
The data flow in 2012 has undoubtedly surprised to the upside. Strong manufacturing and service purchasing managers' indices (PMIs) suggest that activity may have bottomed out, industrial production has got a much-needed boost and exports have begun to re-accelerate sequentially despite an uncertain global environment. These factors have undoubtedly contributed to improving sentiment. But, by all accounts, the optimism currently gripping markets is predicated on two critical outcomes: (1) inflationary pressures finally come off in 2012 allowing the Reserve Bank of India (RBI) to substantially ease monetary policy and (2) the FY13 Budget in March undertaking credible fiscal consolidation, thereby freeing up resources for the private sector. Both of these triggers are expected to result in a softening of interest rates that will help jump-start the much-anticipated and much-delayed private investment cycle. This is important because other triggers to boost sentiment – like pushing ahead with policy reforms – hinge critically on the political outcomes of the upcoming state elections and, therefore, appear fraught with uncertainty.
In light of this, I believe the most important variable to shape near-term macroeconomic outcomes, and thereby determine whether the current optimism can sustain, is the exchange rate. Here’s why. The sharp depreciation of the rupee from August to December was the critical factor in refuelling inflationary pressures in the latter half of 2011. While the year-on-year headline inflation rate moderated in December, it was based on large and favourable, but temporary, base effects. Instead, the underlying sequential momentum of core inflation has re-accelerated sharply since August after the onset of the depreciation. (see Figure 1). This is not surprising. The depreciation increased the rupee cost of all tradables and pressured input costs sharply, which then expectedly seeped into core inflation. What this implies is that while inflation will likely print below RBI’s seven per cent March target, its trajectory after that – once the base effects evaporate – will depend crucially on the rupee. If the currency were to weaken again, and give up its recent gains, inflation will likely tick back up towards the eight per cent mark. In this environment, market expectations of substantial monetary easing by RBI in 2012 (most market participants are expecting at least 100 basis points of rate cuts) will almost certainly be belied, with its concomitant impact on investor sentiment.
What’s worse is that a weak currency will again play havoc with fiscal consolidation in FY13. The fact that the rupee plunged from 45 to 53 over the last five months has likely added at least 0.5 per cent of GDP to this year’s fiscal deficit by causing oil and fertiliser subsidies to surge. What’s more, it has resulted in a sharp compression of margins for firms in the non-tradable sector, thereby squeezing profits, and dampening corporate tax collections. So if the rupee remains weak, chances of a sobering fiscal deficit and a large government borrowing programme in 2012 appear high. That will put further pressure at the long end of the yield curve. The less the fiscal consolidation, the less RBI’s ability to cut interest rates — constituting an adverse double whammy for sentiment. For all these reasons, the rupee’s evolution in the coming months is crucial.
What, then, should one make of the rupee’s sharp rally over the month? The conventional wisdom is that this is an “India-specific” phenomenon. For one, the slew of restrictions imposed by RBI in the forex market have significantly reduced speculation and increased the efficacy of any RBI intervention. Second, the increase in NRI deposit rates has reportedly resulted in a sharp increase in inflows. In addition to these structural changes, the positive data flow, a moderation in inflation, a cut in the cash reserve ratio have all boosted sentiment and contributed to more inflows. And, finally, the fact that the INR has begun to appreciate has induced exporters, who had been heretofore sitting on the sidelines, to sell — thereby reinforcing more appreciation. Increasingly, therefore, the conventional wisdom is that the “structural outlook” on the rupee has turned positive. Talk of the INR touching 60 has quickly been replaced by how quickly it gets back to 45.
Even as these factors may have helped sentiment on the currency, I contend the recent move of the INR has been driven primarily by global factors. Specifically, it represents the classical “January effect” — when global markets are in a “risk-on” mode and capital flows to emerging markets and risky assets. To see this, observe Figure 2 that plots the currencies of India, South Africa, Brazil, and Mexico. The only thing that these countries have in common is that they are large emerging markets with current account deficits (CADs). Notice, the evolution of their currencies is almost identical. Ever since US debt was downgraded in August 2011 and global risk aversion spiked, all CAD countries struggled to attract capital causing their currencies to depreciate. Conversely, once risk appetite returned in January, all these currencies experienced appreciations of a similar magnitude.
What this tells us is that the recent appreciation of the INR has very little to do with India-specific factors. Instead, it has everything to do with global risk appetite. If global risk aversion were to re-surface for any reason – financial stress in Europe, in particular – the rupee, along with all EM currencies, would likely give up most of its recent gains. Given India’s relatively large exposure to European bank de-leveraging pressures and the large quantum of short-term debt that needs to be rolled over, the rupee remains particularly very vulnerable to global risk aversion and moderating capital inflows.
In sum, the rupee remains the key variable to shape macroeconomic outcomes and, therefore, investor sentiment in 2012. And whether the current rupee rally sustains or reverses will critically determine whether the tide is finally turning or whether this is another false dawn. In light of this, what happens in Europe over the next few months could be even more crucial than what happens in Uttar Pradesh.
The author is India economist, JP Morgan
