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In mid-1997, when the East Asian nations ran into currency crises, they all tried different methods of combating the situation. Malaysia adopted the most drastic methods. It imposed capital controls, making it impossible to freely sell ringgit assets and convert proceeds to foreign currencies. Once it had those controls in place, it had more freedom to fiddle with domestic money supply.
This wasn't ideal. Malaysia did see currency depreciation and the stock market also tumbled. But the Malaysian economy suffered less in the way of a deep recession. In fact, it managed some growth even in 1997-98. It also had a faster recovery than Korea and Indonesia. However, it took three or four years for FIIs and foreign direct investors to recover confidence in Malaysian policy even as capital controls were relaxed gradually. In the short-term, Korea and Indonesia suffered more due to leaving their economies open. Both nations saw deep recessions in 1997-98 and also huge currency depreciation. Political upheavals occurred more or less as a direct consequence of the economic hardship.
The long-term results, however, suggest that the Koreans and Indonesians have been rewarded for their faith in free markets. While Malaysia has done quite well since 1998, Korea and Indonesia have both seen spectacular growth. Korea is now a first world economy. Politically too, both countries have become far more open and liberal. Malaysia hasn't.
India's policy-makers are more likely to head in the direction of Malaysia, than Korea or Indonesia. For one, India's policy is made by elderly politicians and bureaucrats who are comfortable with currency controls since they grew up with these. Second, the thought of political turmoil is absolute anathema to Indian policy-makers. It was different in 1991 because the same people were 20 years younger and more willing to embrace the unknown.
We have seen a rapid rollback of financial freedoms in the short time since the rupee started going South. First, liquidity restrictions were imposed on the banking system by means of several measures. Then, gold import duties were hiked. The latest measures include restrictions on Indians investing abroad, and making outward remittances. The trend is clear. If this latest round of controls doesn't buoy up the rupee, there will be further tightening by some means or another.
The current regime could in itself, spark a fear reaction. As capital controls have been imposed, people have become more nervous about further possible restrictions on remittances of forex. This could affect both FIIs and NRIs who have large, high-interest-rate rupee holdings. There has already been substantial capital exit via FIIs selling debt and equity. The current trend of NRI remittances into rupee accounts is negative. We may well see another burst of selling if FIIs decide to reduce rupee exposure before capital controls are further tightened.
It is also unlikely that large scale investment will flow into the Indian economy as capital controls are tightened. In fact, the flows could be in the other direction, despite the controls. The Tatas, Jindals, Birlas, Apollo Tyre, Shree Renuka Sugars, Airtel, etc., have all preferred to invest abroad rather than putting money into India in the recent past.
This means that the rupee is unlikely to be pulled up much by the current measures. It may be artificially propped up for a while as the currency market becomes less open. However, there is already frenetic activity in the related smuggling and hawala industries. The premium on the black-market USD/INR rate compared to the official RBI reference rate will increase.
The current crisis cannot be controlled by administrative measures. The current account deficit will reduce only as and when exports rise considerably to reduce the trade gap. That will not happen until and unless there is investment to set up new businesses, and there is some movement on the ground to the completion of multiple stalled projects. That requires the removal of masses of red tape, which the Indian establishment is obviously unwilling to contemplate.
I think the rupee will fall quite a bit further until a level is reached where Indian exports are competitive and imports are "naturally" squeezed. If history holds, it should end up under-valued for a while. The RBI's own Real Effective Exchange Rate calculations suggest that the rupee should be at 62-plus. It would need to drop considerably lower than the REER before India becomes export-competitive.
Under the circumstances, a focus on export-oriented industries is the best hedge a long-term investor can probably find. The old warhorses of IT, pharma and perhaps, textiles, might be among the better-performing sectors in a long bear market.
