India: Victim of taper scare
US equities and bonds experienced steep losses last week as investors remain uncertain about the future path of Federal Reserve policy. Specifically, the argument runs, if the Fed were to decide as early as next month to reduce monthly purchases of bonds from their current level of $85 billion, bonds would lose a significant element of support, and equity investors would not have the additional liquidity to play with. While these implications for the US financial market are readily understandable, aEURoeTaper ScareaEUR? also claimed a victim on the other side of the globe - - the Indian economy. After Fed Chairman Bernanke said in his Congressional testimony May 22 that the Fed could start the tapering process before the end of the year, (http://bit.ly/17gQ9bzA-) emerging markets benefiting from significant capital flows from the developed world in recent years went into reverse. The Indian economy has been particularly hard hit. Economic growth expectations had already been scaled down to the 5.5% level this year from the torrid 9% + pace in recent years. Infrastructure bottlenecks, recent corruption scandals, and a political transition coming with the next nationwide elections set to occur by May 2014, were all blamed for the growth slowdown. Such fears were accompanied by concerns about capital outflows as investors moved money to safer shores to take advantage of rising interest rates in the United States.The impact was reflected in the trading of the Indian rupee. The currency opened the year at 54.69 per dollar and closed Friday at 61.71. The rupee weakened to over 63.00 today, and the principal equity index fell by 1.5%. The dollar has become some 15% more expensive in rupee-terms in less than 8 months (chart below). Notice that almost the entire depreciation of the Indian currency has occurred since the Bernanke statement May 22, with the dollar still trading at Rs. 55.48 that day. Sharp depreciation of the currency hurts the Indian economy in two distinct ways. First, it increases the cost of oil imports measured in rupees and, since fuel is an important component of the domestic consumption basket, pushes up the inflation rate. Second, higher oil imports add to the deficit on the current account of the balance of payments which has to be financed through capital inflows or a rundown of foreign exchange holdings. And since capital was already leaving the Indian shores following fears of Fed action, the Reserve Bank of India has been forced to sell dollars to finance the deficit. Indian authorities concluded that the situation was not sustainable, and imposed capital controls last week. On August 14 - - eve of Independence Day celebrations - - the annual limit on Indians remitting funds abroad was reduced drastically from $200,000 to $75,000. In addition, Indian companies making foreign direct investments abroad are now limited to 100% of their own book value unless the RBI approves a higher figure. As some analysts had feared, these moves worsened the market panic rather than calm investor concerns. The rupee plunged again on Friday when markets reopened after the holiday, and the Bombay Sensex index fell by 4% (chart below). Indian markets - - both the currency and equities - - could be hit further during coming weeks. Why is India particularly exposed to developments in Washington, DC? While several emerging markets - - Brazil and Russia included - - have suffered capital outflows in recent weeks, IndiaaEUR(TM)s vulnerability is acute because of the growing shortfall in the current account of the balance of payments (chart below). This measure calculates the surplus or deficit on merchandise transactions (exports and imports) as well as services (e.g., dividend and interest receipts and payments). After running small surpluses at the beginning of the last decade, the current account has steadily deteriorated to more than 5% of GDP. Country risk analysts generally consider a 3% level as the aEURoesafeaEUR? maximum for this indicator. Depreciation of the rupee will probably further increase the current account deficit unless the government imposes austerity measures to dampen economic growth and imports. And that is not a palatable alternative either! Economic uncertainties are heightened, as well, by the coming transition at the head of the RBI. Duvvuri Subbarao will retire as the Governor next month and be succeeded by Raghuram Rajan, currently the Chief Economic Advisor to the Prime Minister. Dr. Rajan, a highly accomplished economist - - a former Chief Economist of the International Monetary Fund, he worried about a global financial crisis in a speech at Jackson Hole, Wyoming in August 2005 - - will have his hands full working on the crisis from his first day in office. Prime Minister Manmohan SinghaEUR(TM)s statement Saturday that the country is not going through another crisis similar to 1991 - - when India came close to defaulting on its sovereign obligations - - did little to calm market fears. Despite still excellent long-term growth prospects, the Indian economy seems set for a rough ride during the coming months.