The battle to defend the rupee has well and truly begun. The Reserve Bank of India (RBI) has already spent many billions to prevent any deep dives in the value of the currency against the dollar. Partly as a result of this, its foreign exchange reserves have fallen by $28 billion since the first week of June.
Most other Asian central banks are fighting similar battles. “September has seen a shift in thinking at many Asian central banks. Prior to this month, policymakers appeared content to watch their currencies slide, as they altered their focus from fighting inflation to fostering growth. But in the last few weeks, a number of central banks have taken action to prop up their currencies,” says Moody’s economist Nikhilesh Bhattacharyya in a recent note. South Korea seems to be losing the battle. The won has lost nearly a fifth of its value since the beginning of this year despite the fact that the Korean central bank has spent more than $18 billion to defend the currency.
Tempting though the thought is, comparisons with the Asian financial crisis of 1997 are premature. That was the time when Asian central banks spent most of their foreign exchange reserves to defend their currencies against speculative attacks. Two differences stand out. One, no Asian central bank will today be ready to spend even its last dollar to protect a fixed exchange rate; most are quite happy to live with flexible exchange rates. Two, the searing memories of 1997 and 1998 have ensured that regional central banks have built up huge dollar mountains to prevent a rerun of those vicious years.
In fact, most economists and multilateral institutions such as the International Monetary Fund (IMF) have been saying for some time now that Asia sits on more reserves than can be justified by the precautionary motive. However, a recent IMF working paper by staff economists Marta Ruiz-Arranz and Milan Zavadjil questions this conventional wisdom.
India, too, has no reason to lose sleep right now. The foreign exchange hoard with RBI is still reassuringly large: $288.81 billion for the week ended 5 September. There are various standard metrics used to assess whether a country has enough foreign exchange reserves to maintain stability in times of global turmoil. How many months of imports can be bought with these reserves? Are they more than the foreign debt that is due to mature within a year? How large are the reserves compared with money supply? And what share of volatile capital inflows such as short-term debt and portfolio investments is covered by the reserves?
India is safe on all counts — but it is the final metric mentioned above that RBI should be worrying about right now. Foreign institutional investors (FIIs) have already sold close to $8 billion of Indian equities this year, and it is quite likely that there will be further selling in the weeks ahead if the global financial system slips into deeper trouble. The rupee has already dropped like a stone. And policymakers may have to look ahead to the time when the short-term debt that was raised by Indian companies during the global credit boom of 2006 and 2007 matures and needs to be either repaid or rolled over.
The high dependence on volatile capital flows to finance the current account deficit is one of the clear and present macroeconomic risks for India. This is part of deeper changes in our balance of payments. Economist Avinash Paranjape pointed out these changes to me in a recent mail. The size of India’s balance of payments in 2007-08 was nearly $1.4 trillion, or 140% of the country’s gross domestic product (GDP); it was 60% of GDP in 2004-05. This is a reflection of the globalization of the Indian economy.
But the capital account is now bigger than the current account, which is unusual for a country such as India. “Until about 2005-06 capital account used to be about half or less than the current account. Thus, even without a fully open capital account it increased from $170 billion in 2004-05 to its current level of $750 billion,” Paranjape wrote to me.
These numbers suggest that India is particularly at risk from global financial turmoil. The big worry till now was the high and growing oil import bill — a terms of trade shock that hit the Indian economy out of the blue. But I suspect that the bigger worries in the weeks and months ahead will emanate from the capital account. In the extreme case of savage FII sales in the stock market and the drying up of other capital inflows because of the mess in the Western financial system, there could be growing pressure on the Indian economy and RBI may have to use more of its reserves to protect the rupee.
RBI and its Asian peers have had to face a barrage of valid criticism as they hoarded dollars. Most importantly, they kept interest rates higher as well as imposed fiscal costs on the economies they oversee. But who knows — those excessive reserves may not seem excessive after all?
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