Rupee at 60: Why India is vulnerable to a 1997-style Asian crisis

A collapsing rupee, a soaring current account deficit, a flight of foreign investors... India escaped the 1997 Asian economic crisis, but it may find it harder to dodge the bullet this time around.

Vembu June 26, 2013 15:33:00 IST
Rupee at 60: Why India is vulnerable to a 1997-style Asian crisis

An eerie sense of dj vu grips emerging markets in Asia as they contemplate a sharp depreciation of their currencies, following the sudden outrush of foreign investors, triggered by the US Fed's signalling last week of a tighter monetary policy.

That's because 16 years ago, almost to the week, Asian economies were wracked by a currency crisis after a liquidity-driven bubble burst spectacularly after the US Fed began signalling a tighter monetary policy.

In much the same way as is happening today, foreign investors began withdrawing from the region following a draining out of liquidity consequent on a hawkish Fed policy outlook. But back then, things took a nasty turn for the worse as overleveraged borrowers defaulted on the loans they had taken on for grandiose real estate projects, causing banks to keel over under the weight of the combined loss. Currencies plunged, and the Tiger economies, which were beginning to think themselves invincible, saw their growth vaporise overnight.

Rupee at 60 Why India is vulnerable to a 1997style Asian crisis

A collapsing rupee, a soaring current account deficit, a flight of foreign investors... India escaped the 1997 Asian economic crisis, but it may find it harder to dodge the bullet this time around. Andrew Middleton/Flickr

It took years of painful structural reforms and the steady shoring up of economic fortunes - complete with a restoration of public finances and build-up of foreign exchange reserves - for the Asian Tigers to roar again. And although they appear on the surface to have learnt their lesson from their 1997 experience, those horrific memories have been revived ever since the Fed announcement last week of a possible end to the Quantitative Easing process caused equity and currency markets in emerging economies to reel with shock.

India was largely immune to the 1997 shock, since it was a much more insulated economy than the countries that were impacted. Although the first wave of economic unshackling of the Indian economy had gotten under way in1991, the India growth story hadn't quite picked up momentum. And in any case, India wasn't then as exposed on the capital account as the Asian Tiger economies were.

Ironically, it was in 1997 that an expert group of the RBI headed by SS Tarapore laid out the roadmap for capital account convertibility, conditional on the attainment of specific macroeconomic goals. At the core of the recommendations were the emphasis on fiscal consolidation and financial sector reforms as a precondition to the full convertibility of the rupee by the somewhat ambitious deadline of 2000.

Of course, the 1997 currency crisis across South East Asian economies put paid to that proposal. And although the matter of targeting full convertibility of the rupee has been the subject of subsequent policy recommendation - the Tarapore committee itself address the issue again in 2006 - that proposal has never really gained traction. Fear has been the overwhelming emotion cramping policy action in that space.

But today, with the sense of dj vu triggered by the Fed policy action, it is ironically India that finds mention as being among the most vulnerable to a 1997-style crisis.

That's because in the intervening years since 1997, while the economies that were impacted by the crisis have at least gone some way to erect fences to insulate them from a repeat of those grim times, India appears not to have learnt the right lessons. India is today running arguably among the highest current account deficits, and is ever more reliant on foreign capital inflows. And although it has allowed the rupee to slide to record lows, and has thus averted the malefic effects of a pegged currency that proved indefensible to the Asian economies in 1997, it is not well-placed to profit from that depreciation.

HSBC economist Frederic Neumann notes that India and, to an extent Indonesia, are the obvious exceptions to the region today in terms of the current account deficits they have run up. In India's case, he still reckons, the much weaker currency will ultimately help, while tumbling investment and - if delivered - a narrower budget gap should also limit the need for inflows even if at the cost of growth.

But that sense of fiscal discipline is precisely what the UPA government lacks today as it contemplates elections, which must be held by next May, under the shadow of a dismal record of corruption and misgovernance in office.

"For students of Asia, and those who have lived through the tumultuous summer of 1997, the latest gyrations cause deep unease," Neumann noted. That sense of unease is heightened particularly in India, which is still fighting the last crisis.

In any case, every crisis comes wearing a different mask. Even the Asian economies that are better off than they were in 1997 are nevertheless vulnerable on other fronts - or to other risks that haven't yet come on the radar. For instance, the sharp volatility in asset classes and markets that we saw last week brings with it its own set of vulnerabilities.

And in any case, much of the growth that we've seen in recent years has been goosed up artificially by liquidity flows that are no longer sustainable. And as Neumann points out, liquidity is in reality a "state of the mind", which implies that confidence remains essential to maintain growth. And confidence is one of the many things that India is running low on.

Which is why it's fair to say that while the Asian economies that were impacted severely by the 1997 crisis have at least built some of the defences to avert a repeat of that horror, India is arguably among the most vulnerable to that risk. It may be dj vu all over again.

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