Article by Omkar Godbole
History may not always repeat itself, but it often rhymes.
A Rough Road Ahead?
India Heading Into High Inflation Environment As Markets Forecast Fed Rate Hike
India’s economy and the rupee’s exchange rate could be in for turbulent times reminiscent of the high-inflation environment during the UPA-II regime and the sudden rupee slide of mid-2013.
Only this time, the situation could get a lot worse, as the government and the RBI have little wiggle room to take the steps necessary to keep the rupee from falling sharply amid strengthening expectations of an interest rate hike in the U.S.
What happened in 2013?
The rupee declined from 54 per USD to 68 per USD in the June to August period, after the Federal Reserve or the Fed (the U.S. central bank) signaled a gradual unwinding (taper) of the liquidity-boosting stimulus launched after the 2008 crash.
The Fed cut interest rates to a record low of 0.25% and pumped billions of dollars into the economy after the 2008 crisis, most of which found their way into Wall Street and high-yielding (relatively high-interest rate) emerging economies like India putting upward pressure on the rupee. The hot money inflows kept the rupee somewhat overvalued during the 2009-2012 period. As such, the rupee depreciated sharply after the Fed’s ‘taper talk’ reversed the flow of money.
The rupee sell-off was accentuated by the then high inflation and low confidence in India’s economy due to pervasive scams which flourished under the UPA-II . Inflation reduces the real yield (inflation-adjusted returns) on the national currency, forcing foreign investors to withdraw their money from the country. That leads to further currency depreciation.
However, the 2013 panic was short-lived, as the “Modi wave” and the RBI governor Raghuram Rajan’s anti-inflationary stance restored confidence in the rupee, and Indian economy.
Heading toward a perfect storm?
The path of least resistance for the rupee appears to be on the downside, as the Fed is expected to begin scaling back stimulus from next year, having printed an unprecedented amount of liquidity over the past 12 months.
The central bank’s balance sheet size has more than doubled to near $8 trillion since early March 2020, courtesy of its monthly liquidity injections (quantitative easing, asset purchases) of $120 billion.
The Fed has essentially printed $4 trillion in 14 months – an amount larger than the $3.5 trillion in liquidity poured into the financial system in the 2009-2014 period. The bank also cut borrowing costs to 0.25% a year ago. The record low rates remain in place as of now.
The sheer size of the stimulus has weighed over the greenback. As a result, the dollar index, which tracks the greenback’s value against a basket of currencies, has declined from 103.00 to 90 in the past 14 months.
Interest rates represent the yield or returns available on the domestic currency. Hence, rate cuts and liquidity injections that boost money supply lead to currency depreciation, while rate hikes or liquidity tightening lead to currency appreciation.
As per Bloomberg, markets are now betting that the Fed would start raising interest rates in 2022. Further, the Fed may begin tapering its monthly $120 billion worth of bond purchases.
When an economic giant like the U.S. (with a GDP of $21,000 billion) is expected to or plans to raise interest rates, the money tends to flow out of relatively small emerging economies (India’s GDP is $2,870 billion) reasonably quickly, as seen in 2013.
The sell-off, however, could be more intense this time, as the RBI may not be able to raise rates in lockstep with the Fed to keep the rupee from falling.
That’s because the coronavirus pandemic has battered the Indian economy, and borrowing costs need to stay low to promote recovery. Further, the government is under pressure to employ more fiscal stimulus, having already delivered a couple of big packages since March 2020. Fiscal stimulus refers to increasing government consumption or transfers or lowering taxes, increasing the growth rate of public debt, and is inflationary, as economist Scott Sumner noted in his post at The Library of Economics and Liberty.
Moreover, whether monetary (low rates by RBI) or government (fiscal), the stimulus is like steroids, with inflation as a side-effect. While positive effects on growth are temporary, side effects are long-lasting with inflation leading to currency depreciation and the latter adding to price pressures in the economy.
And it’s not just the Indian government that’s employing fiscal stimulus. The U.S government has delivered record fiscal stimulus worth trillions of dollars, pushing up commodity prices in international markets. Here, we must remember that India is a net exporter of commodities. And that is significant!
Price pressures are already on the rise in India. The wholesale inflation touched a record 11-year high at 10.49% in April, according to Mint. The trend may continue, courtesy of higher global inflation, rising commodity prices, and supply bottlenecks caused by frequent lockdowns. That’s bad news for the currency.
Inflation leads to higher input costs for exports, making a nation’s exports less competitive in the global markets. That leads to a wider trade deficit and causes the currency to depreciate.
Further, inflation reduces the real yield (returns adjusted for inflation) on assets denominated in national currencies, resulting in a drop in hot money inflows. That further adds to the downward pressure around our national currency.
To cut a long story short, India is heading into a high inflation environment at a time when the Fed is forecast to raise interest rates. That sounds like a recipe for a perfect storm on the rupee front.
A Vicious cycle
Note that a rapid depreciation of the currency gives negative feedback, putting the “cart ahead of the horse” – the economy becomes the function of the exchange rate. Usually, the exchange rate is the function of the economy.
A sharp slide in a short period creates panic, shakes confidence (majority of Indians still associate currency depreciation with economic weakness. Some argue India was stronger in 1947 when 1 dollar was equal to 1 rupee). But, more importantly, it raises the cost of imports, mainly energy (oil). That, in turn, leads to a further rise in inflation, leading to weaker domestic consumption and a low growth rate. Meanwhile, imports of non-productive assets such as gold (inflation hedge) tend to rise, leading to additional weakness in the currency. And that’s exactly what happened in 2012-2013.
Eventually, a vicious cycle can set in, where falling currency leads to high inflation, low growth, joblessness, and further currency depreciation and inflation. (Germany in the 1930s, present-day Zimbabwe, Venezuela, Lebanon. Our bankrupt neighbor, Pakistan, is even closer to entering that vicious cycle).
Anti-India forces might do their best to ensure our country faces multiple coronavirus waves in the coming years. That way, the economy never really recovers but faces high inflation, fiscal crisis due to multiple stimulus packages, and full-blown currency slide.
The threat is real from an astrological viewpoint. According to astrologer Milind Chitambar, India, a Makar sign nation, is going through tough 7.5-years of Saturn. The country faced a foreign exchange crisis and the Harshad Mehta scam during the last phase of sadesati in 1992, as noted by Chitamber in his blog post.
While I am not an economist, my decade long experience in global financial markets tells me that the solution lies in adopting a single-minded focus on controlling inflation and building forex reserves. The good news is India’s foreign exchange rates have ballooned to a record high of $592 billion. Much of the recent rise is due to imports being low on account of lockdown. Nevertheless, the rising stock of forex reserves will help the central bank intervene in forex markets to stop any future sudden & sharp drop in the value of rupee.
In national interest, the RBI should adopt an unyielding anti-inflation stance as early as possible and communicate a willingness to raise interest rates, or suck out liquidity if required, and let the government do the heavy lifting with the fiscal stimulus.
Such hawkish communication will keep rupee bears (speculators) at bay. For example, back in 2013, governor Raghuram Rajan went after inflation, which helped stabilize the rupee. (although George Soros and gang will certainly try a counterattack. The notorious international speculator cum power broker reportedly continues to meddle in India’s internal affairs in recent years and, in a similar precedent, shorted the hell out of the British Pound in 1992).
Some might argue that the situation is different today than it was in 2013, which is accurate; however, growth is a gone case anyways. As long as the pandemic rages on, no amount of stimulus will lead to a sustainable rise in the growth rate; however, judicious care must be taken to prevent the steroid from leaving behind unwanted long-term side effects in its wake.
The Government of India should prioritize controlling the second wave, continue to work towards faster vaccination goals, and postpone announcing or implementing reforms/bills that allow anti-India forces to stir mass protests. Responsible Indians, on their part, should extend total support to the government in building AtmaNirbhar Bharat, which will help reduce imports and alleviate downward pressure on the rupee.