India inches closer to crisis as rupee retreats

 India inches closer to crisis as rupee retreats

 

By Swati Bhat and Emily Kaiser

Posted by MydeaMedia

Idea to MM, Dr.Hari Nair Ph.D

MUMBAI (Reuters) - India may face its worst financial crisis in decades if it fails to stem a slide in the rupee, leaving the Reserve Bank of India (Toronto:RBI.TO - NewsRBInull) with a difficult choice over how to make best use of its limited reserves to maintain the confidence of foreign investors.

If the RBI is too timid, it risks adding fuel to the ire of portfolio investors, which India relies on heavily to cover its imports tab.

Aggressive intervention would leave the central bank open to criticism that it is wasting precious money on problems that are beyond India's control anyhow, noteably Europe's debt crisis.

Unlike most of its Asian peers, India has recently been running large current account and fiscal deficits. That means it must attract sufficient foreign money -- namely U.S. dollars -- to close the gap, and a weaker home currency makes that costlier.

This is a perennial problem for India. The current situation is so worrisome because India is grappling with big internal and external economic threats simultaneously. Growth is slowing. Inflation remains high. Political paralysis has stymied domestic reforms.

The RBI, the last line of defence against a currency meltdown, has cautiously begun to support the rupee, but its firepower may be more limited than its $300 billion in reserves would suggest.

Beyond India's borders, Europe is the biggest worry. As its banks deleverage, investment money has flooded out of India's markets. If Europe's debt troubles deteriorate, India could be hit with a balance of payments crisis as severe as the one that forced a sharp devaluation in 1991.

The rupee, which has dropped 16 percent in the past four months, got a reprieve last week after the world's big six central banks banded together to try to ease dollar funding strains, helping it to snap a four-week losing trend.

But analysts widely expect the rupee, trading on Monday at 51.26 per dollar, to resume its slide.

"The Indian currency will be the first casualty of a deterioration in the euro zone crisis," said Rupa Rege Nitsure, chief economist at Bank of Baroda in Mumbai.

If Europe's crisis deepens, India's trade deficit would widen even more rapidly, and it would have even more trouble attracting foreign capital.

"Risk appetite will obviously collapse and gradually the currency crisis is likely to take the shape of a balance of payments crisis," Nitsure said.

Worries about India have spiked in tandem with concern over Europe. UBS hosted a client conference call about India on November 29, which it announced with an email headlined "India explodes." Deutsche Bank sent out a report on November 24 entitled, "India's time of reckoning."

"Suddenly everything seems to be coming to a head in India," UBS wrote. "Growth is disappearing, the rupee is in disarray, and inflation is stuck at near-record levels. Investor sentiment has gone from cautious to outright scared."

India's current account deficit swelled to $14.1 billion in its fiscal first quarter, nearly triple the previous quarter's tally. The full-year gap is expected to be around $54 billion.

Its fiscal deficit hit $58.7 billion in the April-to-October period. The government in February projected a deficit equal to 4.6 percent of gross domestic product for the fiscal year ending in March 2012, although the finance minister said on Friday that it would be difficult to hit that target.

India relies heavily on portfolio inflows -- foreign purchases of shares and bonds -- as a means of covering its current account gap. Those flows are fickle.

Foreign portfolio investors have sold a net $50 million worth of equities so far in 2011 , in sharp contrast to the $29 billion they invested in 2010, data from the Securities and Exchange Board of India's website showed. In November alone, foreign funds pulled $661 million out of Indian stocks.

"The Indian economy is one of the most vulnerable to liquidity shocks in the region, not helped the least by deficits in its key balances," said Radhika Rao, an economist with Forecast PTE in Singapore.

WHERE IS THE RBI?

The drop in portfolio inflows and the hefty current account and fiscal deficits have been a key factor behind the rupee's decline.

The RBI appears to have intervened in mid-November to try to slow the decline. Between October 28 and November 25, reserves dropped by $16 billion to $304 billion, yet the currency still fell by 7 percent over that period.

Trading in rupee offshore forward contracts show traders are betting on the rupee declining a further 1.7 percent over the next three months, and 4.5 percent in a year.

Many economists argue the RBI has been too timid, and deserves part of the blame for the rupee's weakness.

A deputy governor said on Saturday that the central bank would use "all available instruments" to stem a downward spiral.

Other officials have insisted the RBI should avoid "undue" intervention, especially when the currency depreciation is caused by external forces, a message economist Rajeev Malik says could backfire.

"The biggest mistake RBI has made is that it has almost given an open invitation to speculators to short the rupee," said Malik, who is with CLSA in Singapore.

"It is really bizarre for any central bank to openly keep on saying that it will not intervene when there is already pressure on the currency to weaken and globally things are so uncertain."

Contrast that with Indonesia, which burned through 8 percent of its foreign exchange reserves in a single month in September to defend the rupiah from a global bout of market volatility.

The rupiah has weakened in recent weeks after Bank Indonesia twice lowered interest rates. RBI, however, has been among the most hawkish central banks in the world, raising rates 13 times since early 2010. Normally, higher interest rates boost currencies, so the rupee's weakness is all the more significant.

KEEPING POWDER DRY

If the RBI decides to step in more aggressively, its manoeuvring room is more limited than its reserves tally would suggest.

After covering the current account deficit, short-term debt and foreign investment flows, there would be less than $20 billion left over.

J. Moses Harding, head of market and economic research at Indusind Bank in Mumbai, said the RBI's immediate concern would be arresting the spread of currency woes into the money market.

India's banking system already borrows more than $19 billion from the central bank to meet reserve requirements, so if the RBI moved to prop up the rupee, it would drain more liquidity out of an already tight market.

Companies make quarterly advance tax payments around mid-December, which puts an added strain on liquidity.

In addition, a glut of foreign currency convertible bonds, issued when the rupee was much higher, falls due in the first quarter. They include a $1 billion Reliance Communications bond.

The bonds are too expensive at current levels to be converted into stock and the sharp depreciation of the rupee will leave issuers with a heavy redemption bill.

The central bank could boost liquidity by cutting the cash reserve ratio, the proportion of deposits banks must set aside with the central bank as cash. Talk of a cut has circulated in Indian markets in recent days, although some economists argue that such a move could stoke already hot inflation.

"It would be extremely difficult for RBI and the government to arrest simultaneous downward pressures from equity, currency and money markets while struggling to address low growth and high inflation issues," Harding said.

That argues in favor of RBI keeping its ammunition dry in case conditions worsen. If India is indeed heading for a 1991-style balance of payments crisis, those reserves would be vital.

Back then, India rapidly depleted its reserves, forcing a currency devaluation.

But the risk is that RBI will wait too long to act.

"While it is important for RBI to not shed its FX reserves unnecessarily, the approach of allowing such a massive pace of slide in the rupee could backfire," CLSA's Malik said.

(Editing by Neil Fullick)

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