Remember 2007? A gush of foreign capital flooded the Indian economy; the rupee appreciated against the dollar; the Reserve Bank of India (RBI) intervened very heavily in the foreign exchange market to limit the rise of the rupee; its dollar purchases added to the foreign exchange reserves even as domestic liquidity increased to the point when the Indian economy started showing signs of overheating.
Illustration: Jayachandran / Mint
Everything went into reverse gear after the collapse of investment bank Lehman Brothers in September 2008 and the financial panic that followed: Foreign capital rushed to the exits, the rupee tumbled, RBI had to sell dollars to support the domestic currency and there was a severe funds crunch in the domestic money market.
The pendulum now seems to be swinging once again. The world is showing welcome signs of stability. Risk aversion has receded and money is once again flowing into emerging markets such as India, because of higher interest rates and stronger economic growth. US interest rates are close to zero, which means that there are now two currencies to fund the infamous carry trade compared with only one—the Japanese yen—in 2007.
In a recent article, Barclays Capital analyst Andrea Kiguel and head of emerging markets strategy Eduardo Levy-Yeyati say, “After a one-year crisis-linked hiatus, the post-crisis exchange rate landscape seems to be moving ‘back to the future’, i.e. a situation that resembles 2007.”
The two economists have made this observation in the context of what this means for global rebalancing, or the desired process by which the rich countries save more and the emerging markets spend more. The say heavy central bank intervention to keep local currencies down may raise demand for US debt, “condition monetary policy and postpone or derail the pending global rebalancing process”.
It is also worth asking what the revival of capital flows will mean for Indian macroeconomic policy. We only have to look at 2007 to understand the risks involved: a stronger rupee and an asset bubble.
But it is also worth remembering that the macroeconomic situation has changed: India now has a huge fiscal deficit that threatens to crowd out private borrowers and spark off inflation (to the extent that this deficit is monetized). The risks thus are far greater if we have to go through yet another cycle of strong capital inflows followed by a “sudden stop”.
In short, India is even less prepared to handle volatile short-term capital flows than it was two years ago.
Has India returned to 2007? Tell us at email@example.com