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Wednesday, December 20, 2006

The Rise and Rise of the Rupee, Or How to Screech A Galloping Elephant to a Halt Atop of A Dollar Bill

Well my advice on this one - the galloping elephant part (you know, we've had the Tigers, the Lynxes, and the Giant Panda, and now its the turn of the Thundering Elephant to lead the global economy onwards and upward) - is not to try it. The very least that could happen is you get to fall off. But before we get into the full force of rhetorical frenzy here, I'm afraid that I'm not quite done yet with the Economist India correspondent (following my rather hamstrung attempt to caste myself in the role of Emile Zola at his expense yesterday), since as I said at the end of that post, our sterling correspondent, having failed to overheat anything beyond his own curry-ridden palate, has now moved on to what has to be the macroeconomic story of the year, the seemingly inexorable rise and rise of the Indian rupee.

As he himself says on the matter:

The rupee's rise may be less dramatic than that of the Philippine peso, Brazilian real or Turkish lira. But it is uncomfortable nonetheless.
Quite so, just like a strong vindaloo without the de-rigueur mango lassi accompaniment a rising currency produces its own kind of dispeptic discomfort. But hold on a second, mightn't a rising currency in India actually be good news, and in any event inevitable? Nothing it seems is ever considered to be unmitigated good news where India is concerned in the eyes of our valiant correspondant, since everything needs to be tinged with its due and measured dose of schadenfreund.

What then is all the fuss about? Well the rupee certainly is rising. As the Economist India corresponent points out, India's currency has strengthened by about 15% against the dollar in the last year alone, and by over 10%, on an inflation-adjusted, trade-weighted basis, since August 2006. And why is this happening, or why is it happening just now? Again our hero is pretty much to the point:

This vigour is due to a strong inflow of foreign capital, some of it enticed by India's promise, the rest disillusioned by the rich world's financial troubles. The net inflow amounted to almost $45 billion in the year to March, compared with $23.4 billion a year earlier.

So he is pretty much to the point here - India's enchantment is in part a question of disenchantment with others - although I can't for the life of me understand why the latest data he has to hand is from back in March. Can't this guy ever do a professional job? Data up to the start of December is readily available on the Reserve Bank of India website here, and fascinating reading it is. Since this is a moment of almost historic proportions, perhaps my colleagues on this blog will be understanding and permit me a small break with tradition in actually posting an exhibit-A type chart.

As we can see, and bearing in mind that the net inflow of external funds in the year to March - as proxied by the level of foreign exchange reserves held at the Reserve Bank of India - was $45 billion, the net inflow between 31st March 2007 and the start of December has been around $74.4 billion, or not that far from double the total amount that entered in whole fiscal 2007/2008 in just 9 months (and $41 billion of this since 9 August, more on why this date is important later) and fiscal 2006/7 was itself a very strong year for fund inflows, as we have already mentioned. All of this is, of course, simply staggering, but unfortunately, it seems, you aren't going to read about just how staggering it is in the pages of the Economist since over there we are still looking at last years data (the last time I cricised them they said I was cross, this time I am angry aren't I, does it show?). As can be seen directly from the chart, the money really started to flow in from mid-September and continued flooding in at a very fast rate until roughly mid November.

The locus classicus on this whole state of affairs is without a shadow of a doubt Morgan Stanley's Chetan Ahya, and really it was this post of his which alerted me to the extent and significance of what was that was happening in India.

Over the seven weeks ending November 2, 2007, India’s foreign exchange reserves have increased by US$34 billion (annualized inflow of US$250 billion). Indeed, the trailing 12-month sum of FX reserves has increased to US$100 billion. This compares with the average annual increase of US$38 billion over three years prior to these seven weeks. With the current account still in deficit, the increase in reserves is being driven largely by a spike in capital inflows and to a very small extent because of conversion of non-dollar reserves into dollars. During the last seven weeks in which FX reserves have shot up, we believe that capital inflows would have been US$35 billion. Out of this, not more than 10% has been on account of FDI inflows. Non-FDI inflows including portfolio equity and external debt inflows form a major part of these inflows.

While the inflows are pouring in at the annualized run rate of US$250 billion, in our view, currently the country can absorb only about US$40-50 billion of capital inflows annually without causing any concern on attended risks of overheating. The key question policy makers are grappling with is how to manage these large capital inflows. As the strong growth in domestic demand has resulted in overheating of the economy recently, the central bank does not want to leave such large capital inflows fueling the domestic liquidity. Not surprisingly, the central bank has accelerated the pace of the sterilization by way of issuance of market stabilization scheme (MSS) bonds and an increase in the cash reserve ratio (CRR). Over the last 12 months, the RBI has sterilized about 58% of the foreign inflows. The sterilized liquidity (excess liquidity) stock including reverse repo less repo balances, MSS bonds, government balances with the RBI and the increase in the cash reserve ratio has shot up to US$77 billion as of end-October 2007 from US$19 as of end-October 2006.

Now while the issue of whether or not India is now overheating once more raises its ugly head here, the context is now quite different, and it is clear that the Reserve Bank of India is having to struggle with a very different problem set from the one we were looking at back in the winter of 2007/8. The problems that may arise in the wake of such a massive influx of funds, and especially if the flow continues (or even increases further as it may well do if the problems the developed economies experience in 2008 turn out to be greater than appear to be the case at present), and doubly so the if India's attraction only rises further on the back of a discovery that not all the emerging economies are as structurally sound as they appear to be.

The 9 August 2007 date is a significant (and even historic) one, since that is the day that French banking giant BNP Paribas announced it was suspending three of its funds -- Parvest Dynamic ABS, BNP Paribas ABS Euribor and BNP Paribas ABS Eonia -- since they were considered to be unduly exposed to US high-risk property loans. BNP Paribas Investment Partners, a unit of the French bank, chose that day to announce that the funds would forthwith accept no redemptions or subscriptions, and in making this announcement the so called "US Sub-prime Financial Turmoil" problem was born, and with its arrival the history of the entire global economy was given, it seems, a gentle turn of the page.

One outcome of the Paribas decision that no-one perhaps envisaged when it was announced was that half a century of severe distortion and imbalance in global economic dynamics (you know, that old-hat "rich economy"/"poor economy" thing) might be given a hefty push in the direction of unwinding itself across a five to ten year window. Acceleration and recoupling is now the name of the game. (Since explaining all this involves getting involved a little bit in what the Bretton Woods II architecture is all about, as well as in the significance of what is happening in Japan, about which I have previously posted something here, and about what Bretton Woods III might look like, and how quickly it might now have to arrive, I will not enter more into this intriguing topic, but will save it for a separate post next week).

Now I don't think it really needs saying that India is hardly to blame for the sub-prime blowout, or for the fact that the whole Bretton Woods financial architecture is looking extremely shaky at this point in time. One thing is sure though, and that is that given that money is leaving one place (some of the G7 type developed economies), rather than intentionally heading somewhere else, India now finds itself reeling under the weight of a quite sudden and unexpected inflow, which she may seriously be asking herself what it is precisely she has done to deserve, since what seems to be involved is some form of reversal the directional arrows normally though to be associated with the expression "capital flight".

What is obvious to me at least at this moment in time is that, amongst all the growing risk you can see steadily accumulating itself out there (and here I would part company slightly from the Morgan Stanley China team, since I think the dial registering inflation risk in China is now starting to turn dangerously red) India looks to be as good a substitute for a safe haven as you can find these days. And so in the money comes.

The question is that while India's new found growth potential and relatively tame inflationary environment is in part a by-product of the fact that the rupee has been allowed to steadily rise, the ensuing process is not, to use our Economist India correspondent's own euphemism, a comfortable one. And in the same way that the representatives of the European Central Bank express concern about "violent changes in currency values" - meaning by this the unduly rapid rise in the value of the euro - the gentlemen over at the Reserve Bank of India and the representatives of the Singh administration have every right to speak out plainly to the effect that countries like India and Brazil (for all their tremendous potential) simply cannot shoulder the whole weight of the massive global correction which is now in course.

These are developing economies, and the whole path of their development process can be distorted or skewed by an excessively hot-house fashion injection of funds. In this sense I fully endorse the preoccupations being expressed by Chetan Ahya about the rate at which the inflows are pouring in. An annualized run rate of US$250 billion is simply enormous in an Indian context, and historically (in proportional terms) unprecedented anywhere I think. So regardless of the validity or otherwise of Ahya's suggestion that India currently can only absorb somewhere in the region of US$40-50billion of capital inflows annually without producing overheating risks (here we go again, my guess is that this number could be higher, but this is just that, a guess, since I certainly have not done the requisite studies, but who, in all honesty, really has, or is in a position to realistically estimate what is involved here. A brave man, I would say).

This is not the moment to take all this off into those still very much uncharted waters. My friend and colleague Claus Vistesen recently had a stab at identifying some of the issues involved in this Compass and Charts Needed post. Clearly a coordinated and concerted response from the entire central banking community as well as from a rapidly enlarged G7 type forum is badly needed (was the case for enlargement of the G7 ever so clear as it is now, what the hell is Italy doing in there while India and China are out, our institutions simply are not keeping pace with events). I, for my part,only want to register here that something profound and important is taking place, and that there are no easy answers to hand. This is not simply a tepid repeat of events we have all seen far too often in the past, and recipes (which is what I fear we are being offered in the pages of the Economist) will not suffice (even if they are of the softer Chicken Tikka Masala variety rather than the undiluted Vindaloo one). Starting from this recognition, let the debate as to where we go next, and what to do about it, commence!

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