The Uncomfortable Rise Of The Rupee?

Well I'm afraid I'm not quite done with the Economist on India yet (see this extensive post to read the story so far), since our sterling correspondent, undaunted by the failure of all that vindaloo curry he had been eating to overheat anything more than his own digestive tracts our is now worrying about, guess what, the rise of the rupee.

As he says, in a post whose title I have ironically cited in this one:

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 obligatory mango lassi as accompaniment it 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 good news where India is concerned for our valiant correspondant, and everything needs to be tinged with it's due dose of schadenfreund.

So what then is all the fuss about? Well the rupee certainly is rising. Here is a chart showing how it has risen vis-a-vis the US dollar over the last 2 years.




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. Again our correspondent 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.

Although I can't for the life of me understand why the latest data he has is from back in March. Can't this guy ever do a professional job? Data up to the start of December is readily available here, and fascinating reading it is, as you can see it in the chart below.



As we can see, while 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 $74.4 billion, or not that far from double the whole amount that entered in whole fiscal 2007/2008 in just 9 months (and $41 billion of this since 15 August). This is, of course 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 the very fast rate of inflow continued till mid November.


Now the locus classicus on all this is certainly Morgan Stanley's Chetan Ahya, really it was this post of his which alerted me to the extent and significance of what was happening.

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 overheating raises its head again here, the context is quite different, and it is clear that the Reserve Bank of India is now struggling with the problems that may arise in the wake of such a massive influx, especially if it continues, as it may well do if the problems in the developed economies experience in 2008 turn out to be greater than may appear to be the case at present, and again if not all the emerging economies are as sound as they appear to be. Also, India is hardly to blame for this state of affairs, since the money is leaving one place (the developed economies following the sub-prime bust, rather than intentionally going somewhere. It is just that, amongst all that growing risk you can see out there, India looks to be as good a safe haven as you can find these days.

But this is not the moment to take all this into those still uncharted waters. If you want to read more on this aspect of things, then I cannot recommend a better source than Claus Vistesen's Compass and Charts Needed. For my part, I think all I want to register here is that something profound and important is taking place, and not simply a tepid repeat of events we have seen all to often in the past. Starting from this recognition, let the debate as to where we go next, and what to do about it, commence!