Day of the declining dollar

How should India be responding to this trend?

Capital flows of roughly $2 billion per day go into the US every day, in funding the US current account deficit. This is a very big number. For example, in 2003-04, which was a good year for capital flows into India, roughly $20 billion came into India in the full year — and that tiny number gave RBI a major indigestion.

In the past, capital flowed into the US largely because private players internationally were purchasing shares and bonds issued by the private sector in the US. This is a fundamentally healthy situation because private sector buyers are discriminating: the capital flows actually reflected the strength of the US corporate sector. The stocks and bonds issued by US corporations in 2002 turned into greater exports in 2003 and 2004. But from early 2004 onwards, there has been a shift. In 2004, purchases by foreign finance ministries of bonds issued by the US government dominated. This is bad news because it merely funds the US fiscal deficit. US government bonds sold in 2004 merely fill the fiscal deficit and don’t generate exports growth which can help in repaying the bonds in the future.

Most economists believe that this is not a sustainable situation, and adjustments need to take place to reduce the US current account deficit. Two big things will happen in the adjustment: a drop in the US dollar (USD) and a rise in US interest rates. Higher US interest rates inevitably involve lowered US asset prices, including bonds, shares and real estate.

If the US fiscal deficit improves, the drop in the USD and rise in US interest rates will be muted. If the US fiscal deficit thunders along unchecked, the fall of the USD and rise in US interest rates will be stronger.

In a good scenario, the adjustment will be gradual — like what has been taking place in 2004. This will hurt many people. For example, the massively indebted US households will hurt when US interest rates go up and US asset prices go down. In an unhappy scenario, the adjustment will become a bit of a scuffle and more people will get hurt. Global economic growth could get disrupted if the adjustment takes place badly.

From an Indian perspective, the “unhappy scenario” will hurt Indian growth. India is now an open economy. The current account is now 35 per cent of GDP and the capital account is another 20 per cent. A weak global economy will hurt Indian exports. Higher US interest rates will weaken capital flows into India. Tourism revenues in India will drop. The global business cycle now strongly affects the Indian business cycle, and a global downturn could well reverse the present buoyant business cycle conditions.

At the same time, tough times for profits of Fortune 1000 companies is basically good news for India. It is when the going is tough for these companies that their boards will support the drastic surgery of shifting more and more functions to India. This will fuel capital flows to India, and then exports out of India. For India to capitalise on these opportunities, we need to stay focused on solving the bottlenecks which inhibit foreign investors. We need to strengthen ports and airports, and shift to the Goods and Services Tax which would give us India as a single national market. We need to make progress on further removing the bottlenecks which inhibit movements of capital in and out of the country.

Hence, if there is a disruption of global growth, this will indeed hurt in India in the short run. But if we are able to stay focused on building the environment for companies that will participate in globalised production, then global turbulence is good for India insofar as it will provide the impetus for decision makers in Fortune 1000 companies to take harsh measures of closing down factories and sacking workers.

For importers and exporters, this is a time to be much more thoughtful about currency risk and the methods of invoicing. Many Indian companies have been traditionally invoicing in the USD. But the USD is a sinking ship and this needs to be thought afresh. The rupee-dollar exchange rate will be volatile, and companies need to hedge their trade exposures and their capital account exposures.

Households in India can now take $25,000 out of the country every year and diversify their portfolios. In the present situation, there is a strong case for avoiding US dollar denominated assets in forming global portfolios. It is better to own stocks and shares in Europe, UK and Japan. Further, if RBI tries to peg the rupee to the dollar, then Indian rupee assets will be linked to a sinking ship. Hence, if RBI gets back to trading on the rupee-dollar market, this would give strong incentive for households in India to take capital out of the country.

From May 2004 onwards, RBI’s manipulation of the rupee-dollar market has been much smaller. If such conditions continue, then the rupee is likely to appreciate strongly against the USD (simply because the USD is a sinking ship). If RBI gets back into actively trading on the rupee-dollar market, then they will certainly fail to halt this rise of the rupee. But in the process, it will throw up juicy opportunities for profitable currency speculation. If RBI gets back into this game, they will inflict fiscal costs upon the exchequer, which will make things more difficult in terms of coping with the FRBM requirements.

RBI has a millstone around its neck in terms of $125 billion of reserves, a good part of which are in USD assets. The present standards of disclosure and transparency are weak, and no data comes out from RBI about the currency composition of these assets. However, suppose we assume that $60 billion are kept in USD assets. In this case, a five rupee change in the INR/USD rate (eg, from Rs 47 to Rs 42) constitutes a loss to the Indian exchequer of Rs 30,000 crore. These are very big losses, on account of portfolio management by an arm of the Indian government. For example, the present debate about the Employment Guarantee Scheme is a debate about spending Rs 40,000 per year. There is urgent need for greater transparency and accountability about what RBI does on the currency and reserves front.


Ila Patnaik