The frightening thing is that this will happen in stages over the next 12–18 months, and each turn of the liquidity screw can cause a fresh financial storm. Nothing Chidambaram or Raghuram Rajan says can avert the storm.
Learning from the 1997–99 experience, all Asian countries (including India) have built up large forex reserves, reduced leverage compared with 1997, and shifted to floating exchange rates. This makes them far more resilient, so they should not collapse as in 1997–99. But they will suffer severe damage regardless.
Depreciation raises the price of all items that can be exported or imported. Estimates differ, but a 10% depreciation probably sucks out 1–1.2% of purchasing power through inflation.
At Rs 68 to the dollar, currency depreciation is around 25% since May, implying a loss of purchasing power of 2.5–3% of GDP. That is hugely recessionary. It will be reflected in much higher prices of petroleum products, fertilizers, most commodities, and knock‐on transport and material costs.
Chidambaram wants people to invest, but the coming recession will induce every corporate to postpone investment. A falling rupee keeps making Indian assets cheaper in dollar terms, so foreigners thinking India has good long‐run prospects will wait till the Fed’s storm ends.
The fall in purchasing power created by a falling rupee cannot be offset by a huge fiscal and monetary stimulus, as in 2008.
Storm will Continue
Chidambaram has sworn to hold fiscal deficit at 4.8% of GDP. With slowing revenues and rising subsidies, only slashing Plan spending can check fiscal deficit.
Money must be kept tight to check inflation. So, the crashing rupee will generate pro‐recessionary fiscal and monetary forces. This in turn means corporate earnings will crash, a good reason to dump shares.
Corporate’s with large unhedged dollar borrowings will suffer huge balance sheet losses, jeopardizing banks that have financed them. International rating agencies will have good reasons to downgrade India, worsening the climate further.
Rohini Malkani of the finance ministry wrote in this newspaper on Tuesday that using a model based on relative inflation with trading partners, India’s equilibrium exchange rate should be the July level of Rs 58–60 to the dollar.
Many experts say the rupee has overshot and will come back. Really? Remember the same thing was said about the Indonesian rupiah when it depreciated from 2,500 to 3,000 to the dollar in 1997, but it eventually went all the way to 18,000.
Estimates based on fundamentals quickly become meaningless because a crisis changes fundamentals hugely. The crashing rupee has already changed the economy’s fundamentals. Do not think that the rupee has just temporarily overshot, and will revert soon to Rs 60 per dollar. The storm is going to continue well into 2014.