There is a tendency in official circles to link the rupee’s current problems to the crisis in Greece and the eurozone. India will no doubt feel a contagion effect but the deeper problem is that the economy and the rupee are beginning to pay the price for the excessive dependence on capital infl ows, especially from foreign institutional investors and external commercial borrowings. It will not do to blame the Greek crisis for the rupee’s problems.
When the rupee hit Rs 55 to a US dollar last month (since then it has touched even bigger lows) and there was bloodbath on the bourses, Union Finance Minister Pranab Mukherjee stood in the Rajya Sabha like the proverbial boy on the burning deck and assured the House that they were not caused “by any intrinsic weakness of the Indian economy but due to global risk aversion following the heightened uncertainty in the Eurozone stemming from the fresh crisis in Greece”.
He went on to enlighten the House how an election in Greece defeated a party in power and created uncertainty about a package of austerity measures it was committed to put through. He went on to elaborate how uncertainty in Greece reverberated across the globe and hit Indian shores. He made the statement with an air of assurance and asserted that once the eurozone crisis blew over, the Indian rupee would find its own level of stability. Indeed, it is the most simplistic and optimistic of explanations ever given about the gravest crisis threatening the economy. Or, to put it differently, it is the first time ever that the minister conceded that the Indian economy was being affected by the crisis in the eurozone. In the past, he lived in denial.
The Economic Survey for 2011-12 presented to Parliament in March 2012 underplayed the eurozone’s impact on India. It said “Though Indian banks’ exposure to the troubled Eurozone is negligible, funding pressure could impact them”. It also explained that while European banks have to raise further capital due to new regulatory prescriptions, adding to fears of deleveraging, Indian banks were not expected to be directly affected on account of their negligible exposure to the troubled zone. The finance minister had repeated this statement several times in the past.
Refrain of ‘India Is Safe’
Ever since the Lehman collapse in 2008 and the crisis broke out, the refrain has always been that India is safe and is “insulated from the global crisis” by the prudent regulatory measures adopted by the Reserve Bank of India (RBI). The message sent out whenever the rupee or the stock market dipped was that the “fundamentals of the economy are sound” and there can be no harm.
Unfortunately, this complacency or self-congratulation has not carried conviction with economists, academics, and journalists. For more than a year, critics, both from the right and the left, have expressed concerns over the state of our economy and its growing weaknesses. They have urging early action to remedy the imbalances. Bankers and investment analysts have their own agendas, open or hidden, and have become more vocal. Unfortunately, much of this criticism orchestrated in chorus has created an adverse image about our governance, especially on the management of the economy.
Early this year, when a report was drawn up on the BRICS group (Brazil, Russia, India, China, South Africa), India was on the edge and Jim O’Neill of Goldman Sachs who coined the term BRICS felt that in some ways “India is the most disappointing”. India’s public debt-to-GDP hovering around 66% was the second highest among the emerging markets. India, he argued, had lost the crown of being the second-fastest growing economy. While China, Brazil and Russia had built up their strength, India was perceived as the lonely laggard among BRIC members.
Bleakness of 2011
The year 2011 was in many respects a bleak year. It was marked by sticky inflation, directional currency weakness and a series of multi-year lows in the sequential growth data. The monetary policy review released by the RBI earlier this year reported an “almost 36% dip” in inward foreign direct investment (FDI). Foreign institutional investors (FIIs) invested just $9 billion (bn) in 2011 and investments in the earlier two years were $24.3 bn and $23.2 bn, respectively. In recent weeks, the FII flow has become uneven and uncertain due to fears over amendments to tax laws. In a paper (“Foreign Direct Investment Flows to India”, 11 April 2012) the RBI referred to the divergent trends in flows and said, “these could be the result of certain institutional factors that dampened the investors’ sentiments despite continued strength of economic fundamentals”. (Forgive the RBI for shifting the blame to the government!)
There are concerns over the health of banks. The softness in Indian bank bonds is slowly shifting from a story of oversupply to more fundamental concerns. The adverse debt-GDP ratio began to have an impact on the quality of Indian government bonds. It led, in April, to their downgrade by Standard & Poor’s. The other related consequence is that since most of our banks, especially state-owned banks, are loaded with government bonds, they have also been subjected to downgrading. The Life Insurance Corporation (LIC), loaded heavily with government bonds and public sector shares, is the bandmaster.
There are some other worries about our banks. Though the RBI in its Financial Stability Report made an assessment that the financial system was by and large stable, it expressed concerns about some loans souring, especially in retail and housing. One Citibank analyst noted, “Our base case is still for an elongated asset quality cycle with gradual NPL (non-performing loan) deterioration. However, risks remain skewed to the downside – NPL accretion can accelerate if extreme tightness in liquidity, currency and rates combine together.” It is no exaggeration to say that some of these risks are on the increase and seem to work on each other, aggravating their momentum.
Pressure on Reserves
There are concerns over the decline in foreign exchange reserves. It is observed that India’s reserves as a proportion of external debt are increasingly shrinking. Reserves are being used to meet debt obligations. The reserves which just about covered all of our external debt as of March 2011, now cover around 88.5% (as of December 2011). While the reserves declined by 3% during March-December 2011, debt increased by 9.4%. The ratio of debt to reserves is now the lowest since 2003. During March 2008, i e, before the crisis broke out, the ratio was as high as 138%. It is expected to decline further as reserve assets have declined by another 1.3% between December and the first week of April 2012.
According to Bank of International Settlements preliminary data for December 2011, international claims on India payable within the next one year are $137 bn. This can eat up half of our reserves.
Eurozone exposure is seen to be $60 bn. RBI’s Financial Stability Report 2011 had estimated it at 8.6% of GDP. A more worrying feature of the debt profile is that a large part of it is short-term and a substantial part of it falls due in the coming months. This will drain our reserves further unless there is faster accretion which seems unlikely at this juncture. Significantly, these short-term liabilities have been created by the RBI’s own policies to manage the rupee rate. During times when the inflow was declining and the rupee rate went up, the RBI created newer windows like foreign currency loans for corporates, lifting the ceiling on loans, subscription to domestic bonds by FIIs, higher interest rate for non-resident external (NRE) accounts, etc. These were expected to generate additional inflows which would provide a boost to the rupee or hold it. But the bird may come home to roost when the tide turns. Short-term debts will begin to flee and queer the pitch further with adverse consequences. It does not seem that the RBI (or the Government of India or GOI) had adopted any anti-cyclical approaches to managing inflows. Often it was short-termism or ad hoc. In the longer run, they weaken the ability of the RBI to manage the exchange rate.
Balance of Payments Concerns
The balance of payments (BOP) is a major area of concern. It is assessed that the size of the current account deficit is unsustainably large. It is expected to have been around 4.3% of GDP in 2011-12. Though export volumes have been satisfactory, the worrying item is the price of oil which upsets the balance. Gold import has been another. We are dependent more on exports to Europe and these may shrink in the coming months.
The most glaring feature of our policy has been that both the RBI and the GOI have been relying on capital inflows to fill the current account deficit. This was truly a gamble with imponderables. The 2011 RBI paper seems to be in panic when it says, “FDI flows to India remained sluggish...This raised questions especially in the backdrop of the widening of the current account deficit beyond the sustainable level of about 3%.”
In spite of recent theoretical research on the risks attached to capital flows and “sudden stops” done by an array of economists like Kenneth Rogoff, Carmen Reinhart, Easwar Prasad, etc, and in spite of the major rethinking among International Monetary Fund economists over capital convertibility, the government has not heeded to them and has been addicted to capital inflows. While many other countries in Asia and Latin America have imposed taxes on such transactions or tried to regulate the flows, we have been hesitant to adopt any measure. The Vodafone tax episode and the retraction of the government over some of the proposed tax measures would indicate how abject we are on reliance on capital flows. All these years we have continued to provide them with tax concessions and allowed them to operate from tax havens like Mauritius. This undue reliance on capital flows will show its flip side when the happy days are over and global financial markets are hit by hailstorms.
Capital flows have been (and have always been) volatile subject to the vagaries of investor sentiments, monetary policies of advanced countries like the US Federal Reserve or the European Commercial Bank through their quantitative easing (QE). Tragically, our reliance on such flows has created double jeopardy. At one level it has weakened the RBI’s ability to intervene in the market to iron out the volatility in the exchange rate; at another it is robbing the country of foreign exchange reserves by creating excessive short-term liabilities through currency borrowing, etc.
Poorly Performing Currency
This is not an exaggeration. The Indian rupee has been the worst performing currency in Asia, excluding Japan. Though all Asian currencies came under strain, the Indian rupee has been hardest hit (“Asian Currencies Decline This Week on Greece, Export Slowdown”, Bloomberg, 11 May 2012). Between August and December 2011, the rupee declined by 22% against the dollar. It stabilised in February 2012, but the gyration has gone on. In spite of repeated attempts, some of them failed ones, the RBI has not been able to restore the rupee value. As explained by Easwar Prasad of Brookings in a Financial Times report, “The dropping value of the Indian rupee essentially reflects the economic malaise in India as well as the sense about the economy’s vulnerability to external shocks” (“Battered Rupee Highlights India Woes”, Financial Times, 17 May 2012).
The reserves are also reported to have fallen by $2.19 bn leaving a balance of $293.80 bn in the kitty. Though several analysts have recommended aggressive action by the RBI to lift the rupee, there is evidence that the central bank is not able to do so given the outflows which may come about due to the contingent liabilities and the maturity profile of foreign currency debt. Though the RBI has denied this repeatedly at the level of one of its deputy governors, it is discernible that our foreign exchange reserves are well below “comfort levels”.
In January this year the Economist magazine published a graphic chart on the fiscal capability of emerging economies (“Waiting for the Green Light”, Economist, 26 January 2012). It attempted to show which emerging economies had the most monetary and fiscal firepower. It studied 27 countries and used five indicators: inflation, excess credit (the growth in bank lending minus the growth in nominal GDP), real interest rates, currency movements and current account balances. It showed that China, Indonesia and Saudi Arabia have the greatest capacity or what it calls the highest “wiggle-room index”. India occupies the bottom of the scale (27th) along with Egypt. The moral of the graphic was that India does not have the fiscal muscle to be able to engage in massive fiscal programmes.
Urgent Steps Needed
Overall the trends are disturbing and radical steps are necessary to restore the economy to its health. Many academics, economists, investment-bankers, etc, have drawn attention to these trends. Some journalists may be seen to be lobbying for multinational corporations while advocating economic reforms and emphasising on areas like retail, banking and insurance for FDI. We may ignore their litanies or prescriptions. But we can ill afford to ignore their analysis of the malaise in our economy.
We have become highly vulnerable to external shocks and our fundamentals have been weakened in the recent decade. In such a situation, we will be easily sucked in by the contagion erupting anywhere in the world, especially in the eurozone. We will not be serving ourselves if we blame it on Greece.