The global dollar shortage has played havoc with emerging market currencies, which have been plummeting. This has led to a sharp deterioration in the financials of companies in these regions that have borrowed in dollars, while it also pushed up the cost of imports.

Central bank attempts to support the currency have led to a sucking out of liquidity in the local currency. At the same time, the drying up of dollar liquidity overseas has led to companies falling back on the local credit markets for their financing needs, adding to the domestic liquidity shortage.

Also See Comparing Asia’s External Vulnerability (Graphic)

While it is true that many emerging markets currently have high levels of foreign exchange reserves, these reserves have also been diminishing rapidly for countries such as South Korea and India. The dollar swap arrangements will provide dollar liquidity, helping to meet demand for dollars. While the current rally in Asia may be nothing more than a bear market bounce and capital flight from the region as a result of distress sales may resume, the free fall in their currencies will be arrested. At the same time, the reduction in interest rates caused by the rate cuts will also help reduce further deterioration in corporate balance sheets, although emerging market bond spreads remain very high.

Does India, too, need a similar swap arrangement?

The rupee has plunged against the dollar and, in spite of the Reserve Bank of India’s (RBI) attempts to help liquidity, the three-month Mibor (Mumbai interbank offered rate) was at 12.07% on Wednesday, higher than the 11.96% it was at on 20 October, the day RBI cut its repo rate—the rate at which RBI lends to banks—by 100 basis points. And it is possible that the swap arrangements with some countries may increase the relative risk of lending to companies and banks in countries such as India that do not have similar swap arrangements.

How does India compare with South Korea? Are our foreign reserves large enough to meet a worse case scenario?

Citigroup Inc.’s India economist Rohini Malkani has compiled an external vulnerability index for Asian economies, which essentially adds up all possible outflows from the current account balance, external financing and the stock and bond markets, and then divides that number by the central bank’s foreign exchange holdings to arrive at the index. The table is self-explanatory and shows that we have enough forex reserves to meet the worst emergencies. It also shows that South Korea is far more vulnerable than India.

Nevertheless, a run on the currency, should it occur, could lead to reserves being frittered away. Also, Malkani points out: “A key factor to watch is short-term residual debt, which may prove difficult to rollover in the current environment. This would weigh on the capital account to the tune of US$82.1bn."

That the US Fed is willing to play the role as central bank of last resort to emerging markets is, therefore, a comfort and it may be time for India, too, to get that extra bit of insurance.

Further measures by RBI to improve domestic liquidity are also required.

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Graphics by Ahmed Raza Khan / Mint