How do you see the US sub-prime housing loan problem affecting India?
The sub-prime problem and the related collateralised debt obligation problem which has resulted in various hedge funds going bankrupt all of these have to be seen in the context of the US economy - if the economy does well, these will get tackled. My hunch is that the US is not at the bottom of its growth cycle - both Japan and China, which have an impact on US growth are doing well, so there's steam left. However, if oil prices remain disturbed and rise to $90 or so, US growth may fall to below 2 per cent. That's when we have a real problem as capital flows to countries like India will halt.
But don't investors also flock to US treasury in times of trouble?
They do, that's the 'safe haven' concept. But as I said, as long as the US economy's doing well, no one is going to ask for repayment of household debt - US household debt is greater than the US GDP, so asking for repayment of debt will hurt everyone. The chances of Hillary Clinton becoming President also look better and that should also help investors look at the US positively. I can't predict Bernanke, but I don't think he will do anything in a panic - an interest rate cut would help boost US growth prospects.
Should the RBI be trying to defend the rupee or let it go, as happened some months ago? What is the cost of one, and the impact of the other?
Exports and imports together account for around 35 per cent of GDP and they have a multiplier impact on the economy. Then you've got to add FDI (around 2 per cent of GDP) and FII (around 2 per cent) - the FII impact on the real economy is mainly felt through the effect on interest rates. All told, apart from agriculture, the entire economy is sensitive to the exchange rate today, some more and some less.
The IT-BPO sector, which is driving services growth, for instance, will be badly hit with appreciation. I'd say 45-50 per cent of the economy is directly hit by appreciation, and the rest indirectly. Two years ago, I found the direct impact of the rupee-dollar exchange rate on inflation was around 10-15 per cent; now it may be around 20 per cent - if the rupee appreciates 10 per cent, inflation will fall 2 per cent. The growth impact is more complex. Export growth falls by around 3.3 per cent, but imports get cheaper - the lower cost of production would boost consumer demand. I'd have to run the model to get a full solution, but if all else remains the same (partial equilibrium analysis), a rupee appreciation of 10 per cent may increase manufacturing growth by 1.2-1.5 per cent. Typically, growth rates return to equilibrium in one-two years.
So, should the RBI intervene to stop the rupee from appreciating or not? And if so, how?
If the rupee goes below 40 to the dollar, crucial sectors like IT get hit badly their profit margins can absorb just so much, not beyond that. Also, the export sectors that are getting hit are very labour-intensive. I think the RBI deciding to buy $20-30 billion can contain this.
The RBI's monetary statement made it clear that the volume of forex transactions have doubled in the last one year. And now that everyone knows the RBI will protect the rupee, it's a one-way bet for most, so there's a flood of dollars. How will $20 billion help?
What is the annual accretion to reserves? Around $60-70 billion. So if you take $20-30 billion out of this, the impact will be enough. The RBI has taken some decisions on ECB controls and if some decisions are taken on FII flows - if you balance the tax treatment of FII and FDI, which is a fiscal decision, they will slow down FII - the forex inflow may become more balanced.
But aren't pegged currencies like India just encouraging inflows because of their one-way-bet nature?
You're making too much of it since there is a limit beyond which inflows cannot take place. If speculators bring in money through FII, what do they do with it? They put it in the stock market mainly. If too much comes in, given that the economy doesn't immediately start booming, the stock market returns fall. So, the speculators will lose on the stock market and earn on the rupee depreciation - it will balance out after a period. Optimality is the principle of any economy.
Many economists suggest the RBI should aggressively depreciate the rupee, that the kickstart to the economy far outweighs the cost of what will be needed by way of sterilisation.
You can't bypass the market too much on either side. Let's say the RBI intervenes and is able to get the rupee from 40 to the dollar, to 50. Assume the cost of sterilising this can be borne by the budget. What happens now? Portfolio capital will take a hit when it leaves the country, so it will not come in - immediately, rates of interest will shoot up. Exports will grow, but not all are either price-sensitive or have the capacity to ramp up immediately. Rupee oil costs will jump up what exporters will gain with the rupee depreciation, they'll lose with interest rates and inflation rising. Domestic producers will find input costs rising and consumers will have less to spend.
But China has kept an undervalued currency for years with great success. Why can't India do the same?
The big difference between India and China is that China has an export surplus, India doesn't. China owns the forex reserves it holds, India doesn't - China can invest its forex reserves, India has to think of who wants to take back his/her forex. China gets more FDI than FII this is money that doesn't want to go back But the larger point is the one I've just made if you intervene too aggressively, as in taking the rupee to 50 over a short period of time, the impact could be the opposite of what is desired.
