A Seshan

Downgrade and rupee impact

Updated on: Aug 07, 2011
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The RBI may continue with the policy of leaving the rupee alone. There could be capital inflows for taking advantage of the interest differential between the US and India.

The inevitable has happened. Standard & Poor's has downgraded the rating of the United States from AAA (Prime) to AA+ (High Grade). Other leading credit rating agencies, viz., Moody's Investors Service and Fitch Ratings, have said that downgrades are possible if lawmakers fail to enact debt reduction measures and the economy weakens.

US government securities are often used as collateral by borrowers. The short-term repurchase market of $1.6 trillion is an important source of funds for banks and Wall Street firms. Would there be a liquidity squeeze if additional collateral is demanded by lenders? But it is not likely to happen.

Due to the lack of lending opportunities the money pumped into the system by the Fed in the wake of the financial crisis has done a round trip to the central bank.

US commercial banks are so flush with liquidity that they hold reserves of $1.7 trillion as against the required reserves of only $77 billion. Now the Fed pays interest on reserves and excess reserves also. It is reported to be one-tenth of the maximum Federal Funds Rate of 0.25 per cent. The excess liquidity is likely to find outlets in those emerging markets such as India where the rates are attractive.

Impact on India

Of immediate concern to the Indian central bank is the possible fallout of the S&P action on the external sector. The week ended August 5 saw the stock market reeling under the uncertainties concerning developments in the US and Europe.

The dollar-rupee rate has seen a roller-coaster ride in the recent weeks. Apart from exports, the other recipients of forex inflows are the stock, capital and money markets. It would indeed be an irony if India with a BBB- rating from S&P is considered a safe haven, safer than US!

The recent fall in share prices could provide an incentive for purchases by foreign institutional investors. The P/E ratios have come down to around 18 from 24-25 seen a few weeks ago.

There could be also inflows of capital, subject to restrictions, for taking arbitrage advantage of the interest differential between US and India and access to the reverse repo window of the Reserve Bank of India at the attractive interest rate of 7 per cent. What will be the impact of these developments is difficult to predict at this point of time.

Leave it alone

But one thing is clear: the central bank may continue to follow the policy of leaving the rupee alone. The RBI does not have any target rate or band. Intervention is resorted to only when the market is volatile.

The export lobby that has been crying hoarse on the appreciation of the rupee in the past and lobbying for market intervention has been silenced by the spectacular performance of the sector in the recent months.

The appreciation of the rupee helps in bringing down the cost of imports of raw materials including oil. Export industries dependent on imports have benefited greatly by the decline in prices. Export of gold and diamond-studded jewellery is a good example since nearly 80-90 of the raw material is imported.

In all the discussions on exchange rates one rarely comes across such concepts as income and price elasticities of imports and exports and Marshall-Lerner Conditions, etc. Whether Indian exports will be outpriced in international markets depends on the relative strength or weakness of other currencies.

One reason for the good performance of Indian exports despite the rupee appreciation is the fact that the currencies of some competing countries have appreciated even more, providing a net advantage to the rupee.

Less expensive

As one who has travelled abroad, I have always found that Indian goods are less expensive than those of locally-produced goods or those imported from other countries. I have held the view that any appreciation of the rupee should be treated as a correction for its undervaluation in relation to the dollar.

Although the US share in our exports is about 16 per cent, nearly two-thirds of the total is invoiced in dollars. The real problem will arise in case there is a double dip recession in US and Europe.

If the authorities want to avoid rupee appreciation, they may consider administrative controls rather than market intervention. Brazil has imposed a tax on inflows of capital that has restrained them. All the experience relating to intervention either in India or in the West leads to the conclusion that, if it is followed by sterilisation, it takes the currency back to square 1.

The extent of intervention can be only marginal since the total volume of forex transactions either in India or in the world markets is huge. It is possible that a few industries may suffer due to rupee appreciation.

The remedy is in taking fiscal measures to provide relief as was done during the recent crisis. Information technology is likely to be one of the sectors that may be adversely affected.

Apart from the possible resumption of recession in the US lowering the demand for its services, the higher cost of exports due to appreciation may become a double whammy for this sector.

The salaries in the sector are high. The Annual Report of the RBI for 2009-10 clearly articulated the case for non-intervention in the market. It is likely to continue that stance.

Published on August 13, 2011

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