During the last decade, among major economies, India has achieved consistently impressive growth, second only to China. In the first half of fiscal 2010–11, the Indian economy grew at a healthy rate of 8.9 percent. The USD-INR exchange rate is an important indicator of investor sentiment and can significantly impact not only the fortunes of individual firms and sectors but also the government. We believe there is a significant downside risk to the USD-INR exchange rate, and this article will explore some of the risk factors behind this.
Reining in inflation was among the foremost challenges faced by the Indian government in 2010. Driven by increases in food prices, inflation in India has been one of the principal factors driving policy changes. Inflation has been in double figures and the government has not had any success in efforts to bring it down to single figures again. Figure 1 depicts the percentage change in the consumer price index (CPI) over the last 10 years.
Changing landscape of investment inflows
India is one of the fastest growing economies and is considered a favored destination for investment. Nevertheless, it witnessed a decline in Foreign Direct Investments (FDI) in 2010, making it the only BRIC country where this happened. This is troubling as FDI is an important indicator of investors’ faith in a country’s long-term prospects.
Cross-border investment inflows in India follow one of the two routes – Foreign Direct Investment and Foreign Institutional Investments (FIIs). While FDIs are long-term, stable investments, FIIs can be extremely volatile. Hence, most countries prefer FDIs to FIIs. India in 2010 experienced a decline in FDI although FDI increased globally (see Figure 2).
During January-October 2010, FII inflows had already crossed USD 24.5 billion with about USD 6.1 billion worth of investment in October alone. The government raised the amount FIIs can invest in bonds in September 2010, bringing the threshold up to USD 30 billion (USD 20 billion in corporate and USD 10 billion in government bonds), aiding the rise in such inflows and meaning investors can benefit from the higher interest rates prevalent in the country.
Due to these ongoing investments, the Indian Rupee experienced a sharp appreciation against the USD during September–October. The limit was further revised upwards in February 2011 to USD 40 billion in corporate bonds. The additional USD 20 billion can only be invested in bonds issued by companies in the infrastructure sector. Even traditionally risk-averse investors such as central banks are also now looking to invest in the Indian debt market. For example, Malaysia’s central bank, Bank Negara Malaysia, registered as an FII to gain access to India’s debt market in February 2011.
As of December 2010, the value of net inflows was USD 39 billion, the highest single-year investment in India since the beginning of FIIs. Furthermore, the net FII inflow during the period April 2009 – February 2011 was about USD 58 billion. Unfortunately, this news is not entirely positive.
For instance, in 2008, as the global economy foundered, FIIs started to pull out money from the Indian stock market at a breakneck speed. This led to a freefall in the Bombay Stock Exchange’s (BSE) benchmark index, Sensex. FIIs pulled out about USD 13 billion in between March 2008 and March 2009, leading to a 50% decline in the benchmark index value and approximately 30% depreciation in the INR vs. USD.
India needs to be cautious about being over-reliant on these inflows as they are very fickle. One piece of bad news can cause an exodus of foreign money, leading to a sharp fall in the equity markets and depreciation of Indian currency. Figure 3 highlights the close correlation between the trend in FII inflow and the movement of the stock market.
The decline in FDI flows to India highlights the lack of confidence investors have in the India story. Fraud and corruption scandals mar India’s international image as a desirable long-term investment destination.
India facing a “crisis of confidence”
India’s corporate governance structure has become suspect after the Satyam scandal broke in 2009. Satyam, one of the leading Information Technology companies of India, was found to have been “cooking the books” for many years. This exposé led to an erosion of investor confidence in the governance systems in place, especially since the company had been winning corporate governance awards in recent years.
The mishandling of the Commonwealth Games, where allegations of corruption were made against the committee planning the games, further damaged India’s image in the international community. Ineffective management marred the Games – stadiums were not completed on time and the athletes’ village was in poor condition. The authorities have been investigating irregularities in these Games-related projects for more than a year, which has led to a further increase in costs.
The irregularity in the Telecom Ministry and the removal of Minister A. Raja, who was heading it, added to this crisis of confidence. The process of spectrum allocation was found to be biased and corrupt, and might have led to a USD 39 billion loss for the Indian exchequer. To skew the allotment in their favor, the minister allegedly colluded with certain participants of the auction process. This has caused a major embarrassment for the government, as it has exposed the reach of corruption in India’s higher echelons. It has also made investors wonder whether any decision taken by the various ministries can be impartial and not influenced by corrupt practices.
The delayed response to the allegations and the traditionally slow judicial system has not reassured important investors and stakeholders, since there is still no deterrent to any future offenders.
The widespread corruption scandals have reinforced the negative perception of governance deficit in India and raised doubts about the availability of a level playing field for businesses. For example, several global firms who invested in India’s telecom sector have had to write off billions of dollars of their investments.
The corruption combined with regulatory and tax uncertainty will deter many foreign investors. We believe that the negative impact of these scandals is reflected in the decline in FDI. Any more scandals could lead to a flight of capital from the country.
Are remittances under threat?
In 2010, India was the largest recipient of remittances globally, with Indians abroad sending USD 55 billion to their home country, according to World Bank estimates. Migrants from India who settled in the Middle East (ME) countries contribute a major share of these remittances: approximately 48% in 2010.
The recent political and economic upheavals in the ME countries may negatively influence the inflow of remittance. The unrest in Egypt, along with rising unemployment in the United Arab Emirates (UAE) and Saudi Arabia could lead to a reduction in the number of migrants in these countries, and the volatile political environment in Libya and Bahrain is likely to lead to an exodus of Indian expatriates.
The ongoing strife in these oil-producing countries could also hamper the economic recovery of the US economy in coming quarters, putting pressure on remittances received from the country.
Remittances go a long way to keeping the country’s current account deficit manageable. Any decline in these inflows will lead to a widening of current account deficit and influence the stability of the Rupee against the US Dollar.
Worrying trend in current account deficit
During fiscal year 2010–11, the current account deficit is expected to be about 3% of the GDP. The last time India’s current account deficit reached this level was in 1991, the year when the country nearly defaulted on repaying its foreign debt.
For a long time conventional wisdom held that a current account deficit is a necessity for growing economies. But China showed that it is possible to sustain very high growth without running current account deficits, achieving trade surpluses and high domestic savings that resulted in a current account surplus. In India’s case, both these factors are negative and, hence, there is a high current account deficit.
The current account deficit by itself is not a bad thing if it is used to build productive assets (e.g., roads, ports, electricity generation) that deliver long-term growth. Nevertheless, it is not clear that this is the case in India.
Shades of the 1997 Asian currency crisis are already visible. Although India’s economy is different in both size and nature from those of East Asian countries, there are some worrying similarities, e.g., persistent current account deficits, short-term funds that are chasing high growth, and enormous speculation in real estate. There has been a spectacular rise in real estate prices during the past two years, especially in large metropolitan areas such as Delhi and Mumbai, where both residential and commercial property prices have increased by 50% or more.
This increases the risk that instead of building productive assets, the current account deficit will fund speculative investments and lead to a currency crisis when investors realize that the promised returns won’t be there. This is exacerbated by the fact that the more volatile FII money (and not the more stable FDI) is funding the current account surplus.
This risk is also heightened by the fact that India’s capital markets are very shallow and do not have the capacity to absorb even moderate external shocks.
After studying the various demand and supply factors, we have arrived at three likely scenarios:
First scenario – Rupee depreciation. This scenario is likely to occur if oil prices continue to rise or if FII money “exits” because of a crisis of confidence. Based on past evidence, even a relatively orderly outflow of USD 15 billion of FII money over a year could result in the INR depreciating by 22–30 percent. This would imply an exchange rate in the range of INR 55–60 to USD 1.
It could get even worse if the flight of capital were to take place over a shorter period, which would cause massive concern among businesses and the government, since it would imply a higher cost of petrol, diesel, and petroleum products in India, leading to even higher food prices and Consumer Price Index. The current account deficit would balloon and the rising inflation could create a vicious cycle.
Second scenario – Rupee appreciation. This scenario is likely to occur if the FII money continues to flow in and FDI levels improve. The stock markets will climb and there will be a rise in demand for INR. An appreciating Rupee will make imports cheaper and lead to better managed deficits and inflation.
It must be pointed out that Rupee appreciation would erode India’s cost advantage in the export sector and negatively affect the booming ITES sector as well as the textile sector; this, in turn, would invite government intervention. This is what happened just before the onset of the 2008 financial crisis when the USD-INR touched 39 and the Indian government repeatedly intervened in the currency markets to halt the appreciation of the Rupee.
Third scenario – status quo. This is the most benign scenario. The exchange rate continues to move in its current range and appreciates over the long term as the economy continues to develop and India strengthens its position in the global markets. The government’s efforts to improve agricultural infrastructure bear fruit in the longer term and inflation declines. The rate fluctuations do not cause any major disruption in the trade environment.
According to our analysis, during the next two years the probability of the first scenario (depreciation of Indian Rupee by 20 percent is the highest (about 50%) while the other two scenarios have an equal probability of approximately 25 percent each. In other words, there will be pressure on the Rupee unless steps are taken to fix structural issues described in this article. The Indian government and RBI are well aware of this risk and are definitely hoping for the third scenario, in which India essentially grows its way out of trouble over a couple of decades and where they only have to intervene occasionally to smooth out excess volatility.
This article is excerpted from a white paper. Click here to read the entire paper.
Ashutosh Gupta is the Vice President of Investment Research and Chief Transition Officer at Evalueserve. Surbhee Sirohi is a Manager in the Investment Research group at Evalueserve.
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