Singapore: After taking a beating in the past two years, the rupee may finally settle at Rs.70 per dollar, predicts Nizam Idris , managing director and head of fixed income and currency strategy at Macquarie Bank Ltd in Singapore. Idris says the Reserve Bank of India (RBI) must allow the rupee to find its own level. He is critical of the RBI’s recent move to buy back government bonds, which he says will only weaken the currency and end up “subsidizing foreigners who are trying to exit at a better price”.
Edited excerpts from an interview conducted on 23 August, when the rupee closed at 63.35 per dollar:
Finance minister P. Chidambaram said last week that the panic that has hit the markets in unwarranted. “We believe that the rupee is undervalued and has overshot what is generally believed to be a reasonable and appropriate level,” he said. What are your views on this? Also, the rupee has tumbled about 15% in the past three months. What do you think will be the final destination for the dollar-rupee?
I don’t completely agree. Valuation can be viewed from different angles and is relative to a certain time. For me, fair value is based on the assumption that most of the financial indicators are at equilibrium. By that model, what is relevant to India would be when the current account deficit is the lowest, fiscal deficit is at its lowest, inflation is stable...that level would be probably best described in the 2002-03 period. If I were to take that as the fair value level and extend it to effective exchange rate and see where we are currently, as compared to that period, then the rupee started the year overvalued as some other emerging economies are, and the adjustment that we have seen so far is taking us close to fair value. This is a very technical way to look at it—comparing it with historical level where the macro is at equilibrium.
The simpler way is to look at current account; if this is overvalued, then imports should be more and exports too little. India has one of the largest current account deficits as a percentage of GDP (gross domestic product) in recent history. So I don’t think rupee is undervalued, with due respect to the Indian finance minister...I think his objective is to instil some confidence and try to stabilize the market. Signalling is important and, therefore, what he is doing is the right thing, but if I were to verify his statement as an economist, then I disagree.
1991 was the last crisis that India had. There are differences between then and now. In 1991, India had reserves of $13 billion, but now we have about $270 billion, which is about seven months of import cover. In 1991, the currency was devalued twice and weakened 40% in one year, but that was not the end, until it finally stabilized in 1993. By then it had been devalued about 73% from where it started in 1991. The currency has weakened about 20% from the beginning of this year, and this is still not massive.
My immediate answer is 20% depreciation is not sufficient. Currency weakness should be translated to export strength. July export data for India was strong, but you look at the data and you realize that is not broad-based. It was largely coming from export of jewellery. So I am expecting dollar-rupee to weaken another 10% from here and it will take us to 70, in my view.
But, as we know, the dollar-rupee has two legs. The entire weakness in the rupee is also happening at the time when the dollar is strong. For the next six months or till the beginning of 2014, I expect the dollar to continue to be strong. If we get to 70, we are talking about 30% depreciation from where we started at the beginning of this year, which is about half of what had happened during the crisis between the three-year period of 1991-93.
What do you think RBI should focus on—control inflation and let rupee find its own level?
What RBI has done wrongly is trying to manage too many things at the same time. It is trying to manage inflation, currency and, tragically, in my view, trying to manage the bond market. The clear area to prioritize is currency. Now, they have announced bond buying, which, in my view, is totally unnecessary. What does bond buying mean? Here the central bank is artificially creating demand.
In this market, when people are trying to exit, it means RBI is subsidizing foreigners who are trying to exit at a better price. With RBI’s buying, this is not going to change foreigners’ mind. They are still going to exit. Bond buying means easing of liquidity conditions, which basically weakens the currency. So all this is confusing for the market. RBI should focus on one particular objective and communicate it clearly.
Will the current crisis result in a sovereign downgrade for India?
In my opinion, rating agencies should not downgrade now and they should give India the benefit of doubt, given the positive developments in curbing current accounts, trying to narrow fiscal deficit. But there is legitimate reason as well why agencies are threatening a downgrade—if you look at the (Vijay) Kelkar committee report of 2012 (on fiscal consolidation), that basically focuses on the two problems now—the current account deficit and fiscal deficit. They are linked.
But it was not taken seriously enough in my view. Therefore, there is legitimate reason for the threat to downgrade India. The one danger is the tendency to put on populist policies before the election, and if they do so, then you can’t blame the rating agencies for downgrading India. The food security Bill is a sign of populist programmes ahead of the elections.
Can India get through till the elections without a major financial crisis?
I don’t think this crisis is even consequential for the election result, and the Congress is already under a lot of pressure. Crisis or no crisis before the next election, the question that I am thinking is what the BJP (Bharatiya Janata Party), or anybody who comes to power, or a coalition, can do that is better than the current government?
The question still remains the same. What will the next government do? Assuming that it is not going to be Congress party, and I am not saying it because I have any inclinations to support any of the parties, it could be good or bad; good because someone else may have something fresh to offer. But, as of now, nobody has any ideas what to do... What is more important is what to expect post elections. Whoever leads India going forward, what are their ideas? How are they going to deal with all these issues? It could be a good time for a new government because you are taking over from the bottom and it can only go up from here.
What should India focus on—getting its finances back on track and cutting subsidies, or increasing the tax base as only 3% of its population pays income tax? How important is the roll-out of the goods and services tax (GST) to increase India’s tax base?
In the case of India, the large part of the current account deficit is government overspending. Simplifying the problem, it is the failure to push towards a budget responsibility. The fiscal responsibility push was not strong enough. India needs to go back to the basics, which is pushing for a more responsible budget going forward, smaller fiscal deficit. What is sustainable if fiscal deficit falls to 2.5% (of GDP)...
If you get there even in the long term, for that to happen, a lot of subsidy has to go. Let me give you an example. In the case of fuel subsidy, it is a matter of education because it helps the rich more and people don’t know that. The poor consume the least energy. It is the corporates who drive the biggest cars and have their air-conditioners on all the time, and when you subsidize energy, you are subsidizing them. People who ride motorcycles believe this subsidy is for them, but it is the guys who are driving SUVs (sport utility vehicles) who gain the most. Subsidizing education is a better way. Fertilizer subsidy is decent because the agriculture industry in India is still inefficient.
Tax base needs to be increased. GST is vital for India. Just to give you a parallel—Singapore and Malaysia used to have exactly the same corporate and personal income tax rates way back in the ’80s of about 25% for workers’ income tax and 30% for corporate tax. Singapore introduced GST in 1989 and this is indirect taxes through expenses, and with that direct taxes were cut significantly. Direct taxes fell, but revenues went up.
The tax rate in Malaysia is still 30%, so Malaysia has not been able to reduce this. Singapore has been able to do so only due to GST and the impact is far wider. When you lower both income tax and corporate tax, you attract labour, talent, and companies came and set up offices in Singapore. The differences, therefore, is massive. It is more than just 10 percentage points when compared with Malaysia. GST is, therefore, absolutely vital for India in my view.
Can the current crisis lead to civil unrest in India?
Crises tends to do that to a lot of countries. Even in Europe, during the height of the global financial crisis, many governments fell because of civil unrest. When people do not have jobs, they have lesser to lose and so they go to the streets. From that perspective, it is probably a good thing that India has an election coming along. It gives an outlet for citizens to express their dissatisfaction through ballet boxes than through the street. Beyond that, the question really is, what is the big idea to solve this problem? I am waiting for elections to happen so that we can get some clarity on policy direction. Probably after election, there is more room to use fresh capital to put in place some painful, but necessary policies.
Do you think the government’s recent attempts to support the currency such as increasing import duties on gold and luxury items and raising short-term interest rates to curb currency speculation can work?
The current account is how much you import based on how much you export. Trying to boost exports is hard. You can give export subsidies or cut some of the export tariffs or taxes that are currently in place. The other way is to reduce demand for foreign goods. Currency weakness should act as an automatic stabilizer here because as currency weakens, foreign goods become more expensive.
But waiting for that to filter through to the consumer side may be a bit too slow and India, therefore, may have decided to have restrictions on import of luxury goods and precious metals. I think it could help. It will definitely impact imports for sure, but this is only suppressing demand and as soon as you take it away, the demand will come back again. As an emergency step, it will work and you can put it in place until currency has stabilized. The danger is that as soon as you take it away, the pent-up demand is like a spring and it could bounce back rapidly.
Do you think there are opportunities to be made from knocked-down emerging market assets?
Yes, sure. A crisis leads to opportunities and that is why, in a crisis, cash is king as having cash will enable you to make profits. But if you are fully invested during a crisis, then you are in trouble, because your net asset value will fall. I will be looking out for a few indicators to see when the currency is done with depreciation and let me list three of them.
I want to see real yields from Indian bonds rising to a sufficient level where I feel it offers value for me to buy. What is that level—it should be between 3.5% and 4.5% range in real yields. I am talking about 10-year Indian bonds minus inflation. In India, I am taking an average of 7.5% inflation and the 10-year yield is about 8.9%. That will give you less than 2% real yields.
Compare that to the US. You will get a real yield of 0.85%. India’s real yield is only 0.7% more than that of the US and this is not enough as a risk premium and I would rather be investing in the US. This takes us back to RBI’s bond buying. You are suppressing real yields and you are, therefore, not going to attract new foreign investors...
The second indicator is that RBI has to communicate clearly its objective of stabilizing the currency, and one possible way is to become a bit for more hawkish. By that I mean hiking interest rates. One way to communicate a more hawkish stand is to say that we have been focusing on WPI (Wholesale Price Index) all this time because CPI (Consumer Price Index) data was not broad enough, and then state that India will focus on CPI now as an inflation indicator. This will send a message to the market that RBI will be more hawkish.
If you look at both CPI and WPI, the latter has fallen because the central bank has been focusing on debt, indicating that they have successfully suppressed WPI. But CPI has gone the other way up to a couple of months ago. Once there is a shift, people will see that central bank is now targeting higher inflation and is trying to bring it down. When Raghuram Govind Rajan comes in on 5 September (as RBI governor), and if he can bring in such a shift, the markets may like it.
One final issue is the fear of capital controls. When I speak to clients, foreign investors, I see there is fear of capital controls being imposed. A couple of weeks ago, India announced capital control measures for its residents. There is nothing in there to say that the next target will be foreign investors. And I can see why they are worried. (RBI governor) D. Subbarao has now clarified, and that is exactly what he was supposed to have done. The clarification came two weeks after RBI had imposed capital control on locals. So India has to send out the message clearly that it is not trying to draconically prevent currency weakness, or that it accepts some weakness in the currency as that is part of the rebalancing process, but will not have capital controls, and that it will tighten monitory policy despite that hurting the economy.
I would also look at export numbers—if that start to improve—these little indictors start becoming clear, then I would think there are opportunities to go long in Indian assets again. My first focus will be the bond market. At the time of a crisis like this, growth will be compromised and yields will increase. For me, the first area of value in Indian or emerging markets assets will come from the bond market.