India: Crisis Looms with Collapse of Rupee

Econintersect:  The rupee has fallen 16 percent this year as investors sold emerging-market assets on concerns about the possibility of a global recession.  Reuters reports that the resulting financial crisis might be the worst that India has seen in decades.  India is the only member of the BRICS (Brazil, Russia, India, China and South Africa) as well as the being unique among Asian economies in running both current account (trade) and fiscal deficits.  This means that India must attract foreign currencies to offset the two deficits.  Of course, the government could simply issue more rupees but that would lead to an even faster loss of exchange value.

The problem is summarized by Reuters which details the problems facing the national central bank, the RBI (Reserve Bank of India):

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.

The decline in the rupee in 2011 is shown in the following graph, which shows how severe it has been compared to previous volatility.

However, looking at a deeper history, it is seen that decline in the rupee was much greater three years ago in the financial crisis.

There are factors that make concern very high.  The first of these is inflation which has been growing for years but is noticeably higher this year compared to 2008.

The next is that the fiscal deficit is more than double what it was in 2008.

A third concern is that the trade deficit is a bigger problem now than in 2008.

And finally, real GDP has been falling for a longer time than was the case three years ago.

The total picture is one that shows much basis for concern and the RBI is widely expected to take action to increase liquidity, possibly by reducing bank reserve requirements.  But that action (or any liquidity increase) is likely to stoke the already raging inflation.

Sources:   Reuters, Bloomberg, Trading Economics.com and OANDA.com

Hat tip to Sanjeev Kulkarni.