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.