 "Rupee crashes past 72: If the American hand continues, Indian currency can drop to 75 to a dollar")
Editor’s note: The Indian rupee has crashed past the 72-mark against US dollar and continues to be on a roller coaster ride. The sudden fall has caught the government and central bank off-guard. High volatility in global crude oil prices and ballooning current account deficit figures back home have been blamed for Rupee’s free fall. Does rupee at 72 rings alarm bells to the Indian economy or is there an opportunity in the currency crisis as the Narendra Modi government claims? This is the fourth part in a series in Firstpost where experts examine the economic impact of the Rupee’s fall.
The dollar is now worth around Rs 72.45. At the beginning of the financial year, in April 2018, it was worth around Rs 65.10. Between then and now, the rupee has fallen by 11.2 percent against the dollar. Multiple reasons have been offered for this fall. Right from rising oil prices to the fact that over the years, Indian inflation has been higher than that of other countries, and the value of the rupee needs to adjust for it. Further, Indian exports have been flat.
But one factor that hasn’t been explored enough is the foreign hand or put it more specifically the American hand, and the role it plays in determining the dollar-rupee value.
In the aftermath of the financial crisis which broke out in September 2008, when Lehman Brothers, the fourth-largest investment bank on Wall Street, went bust, the Federal Reserve of the United States, the American central bank, decided to print and pump money into the American economy. The central bank printed money and bought treasury securities and mortgage-backed securities. Treasury securities are financial securities issued by the American government to finance its budget deficit i.e., the difference between what it earns and what it spends.
Mortgaged-backed securities are financial securities issued on the securitisation of mortgages. The idea was to buy these financial securities, pump money into the financial system and drive down the interest rates. This was done with the hope of getting people to borrow and spend more, and companies to borrow and expand.
While people cut back on borrowing. They had already borrowed more than they could afford to repay in the run-up to the financial crisis. Companies borrowed in order to buy-back their shares. In the process, they pushed up their earnings per share.
The stock market rewarded the higher earnings per share and pushed up stock prices. In fact, in 2017, the ratio of market capitalisation of listed stocks to the gross domestic product in the United States was at an all time high level of 165.7 percent. The easy money which became available at low interest rates encouraged institutional investors to borrow money and invest them in financial markets all over the world. This included the Indian stock market as well as the debt market.
While a lot of foreign money borrowed at low interest rates came into the Indian stock market, what is not well-known is that a good amount of the money was invested in the Indian debt market as well. Between, 2009-2010 and 2017-2018, the foreign institutional investors invested Rs 3,92,884 crore in the Indian debt market. The idea was to borrow at low interest rates in the US and invest that money in the Indian debt market, and earn a higher return. Arbitrage was at play. Of course, all this became possible because of all the money that was printed and pumped into the financial system, by the Federal Reserve of the United States.
The Fed has now decided to gradually suck out all the money that it has printed and pumped into the financial system. It plans to do so by selling treasury securities and mortgaged-backed securities it had bought in order to pump money into the financial system.
At the beginning of the year in January 2018, the Federal Reserve had total assets worth $4.44 trillion. Since then it has fallen to $4.21 trillion. This basically means that it has managed to shrink its balance sheet to the extent of $230 billion. This also means that the money it had printed and pumped into the financial system to lower interest rates, has come down to that extent. Further, with a lower amount of money going around in the financial system, the interest rates are likely to go up, in the days to come.
In this environment, staying invested in Indian debt does not remain as lucrative as it was in the past, for a foreign institutional investor. The returns that can be earned from investing in debt are limited Hence, it makes sense for the foreign institutional investor to sell out of their debt investments and leave India.
As mentioned earlier, between 2009-2010 and 2017-2018, the foreign institutional investors had invested Rs 3,92,884 crore into the Indian debt market. Since the beginning of this financial year in April 2018, they have sold debt worth Rs 41,831 crore, which works out to 10.6 percent of the amount they had invested post-financial crisis breaking out.
How does this impact the value of the rupee against the dollar?
When foreign investors sell their investments they get paid in rupees. In order to repatriate this money, they need to convert these rupees into dollars. This increases the demand for dollars, and hence, pulls down the value of the rupee against the dollar. And that is precisely what has been happening.
As foreign institutional investors sell out of their debt holdings, convert their rupees into dollars, the demand for dollars has gone up. This is one of the reasons that has pulled down the value of the rupee against the dollar.
In the months to come, if the Federal Reserve keeps shrinking its balance sheet, the foreign institutional investors will keep selling out of the Indian debt market. It is worth remembering here that the investment of foreign institutional investors in the Indian debt market before 2009-2010 was all of Rs 21,390 crore. On the other hand, the investment in Indian stocks had stood at Rs 2,24,268 crore.
Hence, investing in Indian debt became an attractive proposition only once money could be borrowed at low-interest rates in the United States. If the Fed continues to shrink its balance sheet, interest rates in the United States will go up, making the Indian debt trade unattractive. This will lead to more money going out of India.
Imagine what will happen to the value of the rupee against the dollar, if the foreign institutional investors who have invested in debt, sell some debt, and take out around Rs 1,00,000 crore from India. Of course, it is not as simple as that. If the Fed keeps shrinking its balance sheet, it will keep sucking out money from the financial system and in the process interest rates will go up.
High-interest rates go against the entire idea of America as it has evolved over the last three to four decades. The so-called American dream can only be fulfilled through low-interest rates. It will be interesting to see for how long the Fed goes with the idea of shrinking its balance sheet. It is already running into political resistance.
If this continues, i.e., the Federal Reserve keeps sucking out dollars out of the financial system, interest rates in the United States will rise. This will lead to foreign investors getting out of the Indian debt market. This will push up the demand for the dollar. If this continues dollar can touch a value of Rs 75 as well.
The Reserve Bank of India will try and defend the value of the rupee. But the only lesson that we learnt from the 1997 South East Asian Financial Crisis was the fact that the central bank of a country should not become obsessed with the idea of defending the value of its currency at any particular value. That is a recipe for clear disaster.
(Vivek Kaul is the author of Easy Money trilogy).
Read Part 1: Rupee in free fall: A weaker currency may be a temporary setback, but can check Chinese imports
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