Like we always do, let's begin with a prayer.
Let’s pray that US president Donald Trump’s Iran, trade and other theatrics do not put us in a pickle. That crude oil prices quickly correct back below $60 a barrel. That investors don’t discover still more reasons to scramble out of emerging markets, and India.If our prayers are answered, we can pat ourselves on our backs, scoff at the naysayers, declare that everything is fine, and again kick our large can of issues around exports, imports, and external and internal imbalances down the road.
What if our prayers are ignored? We’ll live through interesting times – again. The vulnerabilities
On the external side, our core permanent balance across our current account and foreign direct investment deteriorated to a deficit of $18 billion in fiscal year 2018. Oil was not the only culprit – disappointing export growth, rising gold and electronics imports, and a declining net foreign direct investments - all contributed.
This permanent balance could further deteriorate to a deficit of $35 billion in FY19. That’s about $3 billion of core outflows every month.
In the last fiscal year, the core outflow was more than amply covered by larger, opportunistic, reversible inflows including foreign portfolio investment (FPI) in debt, net exporter selling, and other speculative, carry-seeking positions. These flows strengthened Indian rupee despite the deteriorating core balance, likely hurting our current account further.
Reversible flows are fair weather friends. With global and domestic macro sentiment deteriorating, we have seen $6 billion of debt FPI outflows this fiscal year, and $1.5 billion of NRE outflows in April 2018.
Between FY14 and FY18, we allowed $120 billion of reversible flows to come in. Not all of this will reverse, and the RBI still flaunts large foreign exchange reserves of well over $400 billion. But large waves of panicky currency outflows test our resolve and market savvy much more than inflows do.
The response playbook
So what will the Reserve Bank of India do? Monetary Policy Committee decisions and RBI forex intervention impact the external sector, but there isn’t a well-articulated policy framework or debate around this.North Block will of course be concerned about rupee depreciation. Sensational headlines around the rupee weakness and cartoons featuring petrol pumps are guaranteed to make our
babus and netas wince. One way to spare the voter, for now, would be to take the stress onto the fiscal deficit instead – but that brings its own challenges. The other short-term solution, and Delhi does focus a lot on the here and now, would be to instead control the rupee.
Expect, therefore, that RBI will likely continue to flex its currency reserves with a brave face. They may already have intervened to the tune of $20 billion or more this fiscal year.
But what if the negative sentiment builds up further? We can guess how things would play out then.
The crisis contingency playbook
Sadly, our institutions will blame the crisis on the external trigger and everyone else except themselves. Whatever the proximate cause, we would have collectively put ourselves in a vulnerable spot with unaddressed external and internal imbalances – including a suffering external trade sector, an accumulation of reversible flows, a rising revenue deficit, and a floundering banking system.
We will then await the next masterstroke(s) that our powers-that-be conjure. In 2013, it was a 300 basis points policy rate hike, followed by RBI’s subsidised swap scheme to bring in non-resident (FCNR) deposits. These and other such homegrown remedies could be on the table, never mind the large hidden costs and imperfect science that they involve.
We will emerge out of any crisis, as we always do. Notwithstanding our policy and administrative deficiencies, India’s true long-term potential is robust enough to bail us out.
Strangely therefore, whether our prayers are answered or not, the final outcome could end up the same. We will likely end up eventually patting ourselves on the back, and kicking the can down the road.
If only we looked beyond the short-term
We can live up to our long term potential much better if we addressed core issues head-on. These will take time to resolve, and will require hard work – a departure from the quick fixes that we usually look for.
Our exporters face challenges around infrastructure and ease of doing business, and these need to be addressed. On imports, our domestic industry needs help – we have to find a way of making smartphones and other widgets in India. On capital flows, we have to make some of the reversible flows such as FPI in debt more permanent and productive. The recent set of steps to allow more short-term FPI debt investments risks the opposite. Inclusion of our debt in global bond indices will take a long time, but will be well worth the effort. On banking, while we’re progressing on recognition of the true stress, we now need to recapitalise banks (even further), resolve bad loans, and restructure banking. Essentially, Delhi needs to dust off the PJ Nayak report and implement it – and eventually give up the control it exercises over public sector banks.
Besides legislative and executive remedies, on the policy front, we should review our monetary policy and currency intervention framework. Trade and stable capital flows need a competitive rupee. Our current policy framework brought about the vulnerability of accumulated reversible flows, and an overvalued rupee. We need a policy framework that at least recognises and debates external and internal imbalances better.
Will someone volunteer to bell the cat, please?
Ananth Narayan is Associate Professor-Finance at SPJIMR. He was previously Standard Chartered Bank’s Regional Head of Financial Markets for ASEAN and South Asia.