The Rupee in Distress
June–August 2013
Partha Ray*
Abstract
This paper looks into the episode of sharp depreciation of the Indian
rupee (INR) during June–August 2013 when the rupee-US dollar (INR-USD) exchange rate came down from 56.765 in the beginning of June 2013 to 67.8787
on August 29, 2013, indicating a depreciation of nearly 16 per cent over the
three months. This evoked strong reactions from policymakers and analysts
alike and cast some doubt on India’s macroeconomic fundamentals. The immediate trigger behind this adverse development in the INR-USD exchange rate
came from the news/hints of possible tapering off of the rate of quantitative
easing (QE) in the US in end-May 2013 and the associated capital outflows
primarily on account of foreign institutional investments (FIIs). Interestingly, the
outflows occurred both on account of debt and equity. However, an unsustainable current account deficit (CAD) incurred by the Indian economy over the
last few years and its dependence on foreign capital flows for its financing the
CAD made the Indian economy vulnerable to such external shocks. Faced with
the compulsions of the impossible trinity, the Reserve Bank of India (RBI) did
not indulge in massive intervention in the foreign exchange (forex) market to
defend the rupee. The cross-country experience during the reference period also
suggests that countries with high CAD were more exposed to such speculative
attacks on their currencies. Following the explicit announcement of the US
Federal Reserve (US Fed) for deferring the decision to taper off the extent of
QE in September 2013 and the various measures implemented by the Indian
authorities, there have been some improvements both in the current and capital
accounts of India’s balance of payments (BoP) over the last six months or so.
* The author is Professor, Indian Institute of Management Calcutta (IIMC).
The paper is based on the author’s presentations at ICRA’s Monthly Workshops at Kolkata in August and September 2013. The author is indebted to Professors Mihir Rakshit,
Dipankar Dasgupta, Amitava Bose, Asis Banerjee, Susmita Rakshit, and Soumyen Sikdar
for their comments on these presentations. The author also gratefully acknowledges
the discussion on some of the relevant issues with Professor Anup Sinha at an informal
presentation at IIMC in September 2013. The author is indebted in particular to an
anonymous referee for the detailed comments on an earlier draft of the paper. The usual
disclaimer applies.
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An unsustainable
CAD incurred by
the Indian economy
over the last few
years and its
dependence on
foreign capital flows
for its financing
the CAD made the
Indian economy
vulnerable to
external shocks.
41
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The exchange
rate of the rupee
witnessed a sharply
depreciating trend
during the period
June–August
2013. The situation
assumed almost a
panic proportion
with various
analysts suggesting
that the value of the
rupee would settle
at Rs. 70 per USD.
42
While such volatility in the exchange rate could be the price that an economy
has to pay for its increasing openness, for a credible currency regime, India needs
to have serious introspection on its CAD and its associated financing options.
I. Introduction
The forex market in India experienced significant volatility
during 2013. In particular the exchange rate of the rupee witnessed a
sharply depreciating trend during the period June–August 2013. The
INR-USD exchange rate was down from a level of 56.765 in the beginning of June 2013 to 67.8787 on August 29, 2013—a depreciation of
over 16 per cent. The situation assumed almost a panic proportion with
various analysts suggesting that the value of the rupee would settle at
Rs. 70 per USD (Rajwade, 2013; Tarapore, 2013). Financial market
players were becoming impatient and pressure was put on the authorities to do something to arrest the relentless slide of the INR. People,
from policymakers to the man in the street, were perturbed as well. In
some quarters apprehensions were expressed whether India was on the
verge of another 1991-like crisis. Predictably, policymakers tried their
best to talk up the exchange rate. Thus, the Finance Minister in a statement on August 23, 2013 is reported to have said, “The panic that has
gripped the currency market is unwarranted; we believe that the rupee is
undervalued and has overshot what is generally believed to be a reasonable and appropriate level.” (The Economic Times, August 23, 2013.)1
But what accounted for this extreme volatility of the rupee
during the four months? Was India a victim of speculative attack of
currency traders? Or, were India’s fundamentals so bad that such a fate
was inevitable? Many such questions have been raised in this context. It
is not that economists were unaware of the possibilities of such adverse
developments. Rangarajan and Mishra (2013) while analyzing certain
long-term trends of the Indian economy stated that the estimated current account deficit for 2011–12 at 4.2 per cent of GDP was significantly above the level that could be sustained over the medium term. The
RBI too in its Annual Report for 2012–13 had indicated the sustainable CAD for India to be at 2.5 per cent of GDP. In fact, Sen (2013)
found the Indian story of nominal depreciation of the currency to be
entirely predictable and squarely blamed the official policy of permitting capital inflows to finance the CAD for the adverse developments
on the exchange rate front.2 However, while such adverse exchange rate
1
http://articles.economictimes.indiatimes.com/2013-08-23/news/41440810_1_subbarao-rbi-governor-exchange-rate.
2
Sen’s take on the Indian story is as follows: “Sustained capital inflows caused
a real appreciation accompanied by a very high trade deficit and a rising current account
deficit. The Indian contribution to this entirely predictable story was that somewhere
along the way it picked up high inflation that has now become entrenched in expectations (and the Reserve Bank of India is solely to be blamed for this). This happened as
the economy was slowing down. Gold imports, acting as a hedge against inflation, have
shot up. The crisis would have occurred at the time of Lehman’s collapse but was averted
because of the introduction of quantitative easing (QE) that generated liquidity in the in-
developments could no doubt have indicated the fragility of India’s macroeconomic fundamentals, comparing it to the 1991 crisis was entirely
misplaced. (Krishnaswamy and Kanagasabapathy, 2013; Appendix.)
It is against this background that the present paper takes a look
at the episode of rupee depreciation during June–August 2013 and argues that the reason for it lay partly in the talks of tapering off the pace
of QE by the US Fed officials (and the consequent capital outflows from
India) and partly in some questionable elements of India’s macro fundamentals that cast doubt on India’s BoP sustainability on the external
front in the minds of financial market players.
The rest of the paper is fairly straightforward. The extent of
rupee depreciation is tracked in Section II. Section III is devoted to the
drivers of such sharp depreciation in the external value of the rupee,
viz., tapering talks, the consequent capital outflows, and India’s weak
fundamentals. Our diagnosis is supported by an analysis in Section IV
of the trends in exchange rates of other Emerging Market Economies
(EMEs) during the reference period. The next section is devoted to a
discussion of the crisis management measures adopted by the Indian
authorities. Section VI concludes the paper.
II. Extent of Recent Volatility of INR
How volatile was the INR? In contrast to many Asian economies, a distinguishing feature of the INR has been that it has shown
two-way movements (Chart 1a). Despite some fluctuations, it may not
be an exaggeration to say that the rupee has been able to avoid large
volatility over a prolonged period of time. This is in consonance with
the professed policy objective of the RBI, which has been summarized as
follows: “RBI does not have a fixed ‘target’ for the exchange rate which
it tries to defend or pursue over time; RBI is prepared to intervene in
the market to dampen excessive volatility as and when necessary; RBI’s
purchases or sales of foreign currency are undertaken through a number
of banks and are generally discrete and smooth; and market operations
and exchange rate movement should, in principle, be transaction-oriented rather than purely speculative in nature.” (Jalan, 2003.) The recently
submitted report of The Expert Committee to Revise and Strengthen the
Monetary Policy Framework (Chairman: Urjit Patel, Deputy Governor,
RBI) also endorsed this view when it commented that: “The RBI does
not target a specific rate or level for the exchange rate … the RBI intervenes in the market only to smooth exchange rate volatility and prevent
disruptions to macroeconomic stability.” (RBI, 2014; p. 11.)
So far as the medium-term trend of the INR-USD exchange rate
is concerned, note that over 2008–2013 the INR depreciated for a large
ternational financial markets. Now the slightest whisper about QE being eased out causes
panic in India.” (p. 14.) In a comment on Sen (2013)’s paper, Correa (2013) criticized the
policy of the RBI in recent times to increase the repo rate for attracting capital inflows as
well as for controlling inflation.
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In contrast to many
Asian economies,
a distinguishing
feature of the INR
has been that it
has shown twoway movements.
Despite some
fluctuations, it
may not be an
exaggeration to say
that the rupee has
been able to avoid
large volatility over
a prolonged period
of time.
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Chart 1
INR-USD Exchange Rate
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a. During January 2008–December 2013
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Given that India
had been incurring
deficit in the current
account, in many
b. During April 2013–December 2013
a case any drastic
movement in the
exchange rate of
the INR closely
corresponded
with the pattern
of inflows and
outflows on the
capital account.
Source: Bloomberg.
part of 2008, followed by a mildly appreciating tendency till mid-2010
(Chart 1a).3 Since then it has been on a depreciating trajectory coupled
in between with some episodes of rupee appreciation vis-à-vis the US
dollar. Given that India had been incurring deficit in the current account, in many a case any drastic movement in the exchange rate of the
INR closely corresponded with the pattern of inflows and outflows on
the capital account (or what the International Monetary Fund, or IMF,
calls “financial account” these days). Particularly striking, as already
indicated, was the sharply depreciating trend of the rupee during May–
44
3
Note that since the chart plots daily INR-USD exchange rate any upward
movement would indicate a depreciating rupee and a downward movement an appreciating rupee.
Table 1
Crossing of Psychological Marks in INR-USD Exchange Rate
INR-USD Exchange Rate Mark
Date
55
60
65
67.88 (Peak)
May 21, 2012
July 3, 2013
August 23, 2013
August 29, 2003
1
2
3
4
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Source: Bloomberg.
August 2013 (Chart 1b),4 a trend which however started reversing from
September 2013.
In fact, in terms of the psychological marks of multiples of five
in the popular perception the scenario appeared starker. The INR-USD
exchange rate was 55 on May 21, 2013, but within three months it
depreciated by 10 and moved to 65 on August 23, 2013 (Table 1).
We turn in the next section to look into the factors behind the
relentless fall of the rupee during this period.
III. Drivers of Volatility
In discussing the drivers of volatility some basic facts are important to take note of. First, barring a few years India has long been
incurring deficits on the current account (Chart 2). Second, the CAD
Chart 2
Current Account Deficit, Foreign Investment and INR-USD Exchange Rate
during 1991–2013
Source:
Particularly striking
was the sharply
depreciating trend
of the rupee during
May–August 2013,
a trend which
however started
reversing from
September 2013.
Handbook of Statistics on Indian Economy, 2012–13, RBI.
4
Given that inflation in India has been much higher than in advanced economies, such movement in the nominal exchange rate is also reflected in the real effective
exchange rate (REER). Thus, both the 6-country and 36-country REER of India were also
on a depreciating trajectory.
45
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Table 2
Select Items of BoP: 2012–2013
Money
&
(USD billion)
20122013
Finance
Jan–Apr–July–Oct– Jan–Apr–July–
Oct–
MarJuneSept Dec MarJuneSeptDec
J u l y . 2 0 1 4
1. Current Account
1a) Merchandise
1b) Invisibles
2. Capital Account
2a) Foreign Investment
o/w Foreign Direct Investment o/w Foreign Portfolio Investment 2b) Loans
3. Foreign Exchange Reserves
(Increase – / Decrease +)
Memo: INR-USD Exchange
Rate (Min – Max; in Rs.)
–21.8–17.1–21.1–31.8 –18.2–21.8 –5.2–4.1
–51.5–43.8–47.8–58.4 –45.6–50.5–33.3
–33.2
29.826.826.726.6 27.528.728.1
29.1
16.616.520.731.5 20.520.6–4.8
23.8
15.3
1.9
15.9
11.9
17.0
6.3
1.5
8.5
1.4
3.8
8.2
2.1
5.7
6.5
8.1
6.1
13.9
–1.9
7.7
9.8
11.3
–0.2
–6.6
2.4
2.76.05.2
10.8 9.23.6
–0.5
3.0
5.7
–0.5
0.2
–0.8
–2.7
49–53
51–57
53–56
52–56
53–55
0.3
10.4 –19.1
54–61 59–68 61–64
Source:RBI.
The second and
third quarter of the
calendar year 2013
witnessed sharp
depreciation of the
rupee, with the
exchange rate of the
USD moving from a
minimum of
Rs. 54 to a
maximum of
Rs. 68.
46
as a percentage of nominal GDP has gone up steadily over the last 10
years and touched nearly 4.8 per cent by 2012. Third, the deficits were
met with inflows in the capital account primarily in the form of foreign
investment, in which foreign portfolio investment played a significant
role, particularly over the last 10 years. Fourth, foreign portfolio investment is sensitive to news and market gossips and the players who are
active in the market for foreign portfolio investment (both debt and
equity) tended to exhibit herd behaviour.
Trends in more recent quarters are provided in Table 2. The
second and third quarter of the calendar year 2013 witnessed sharp depreciation of the rupee, with the exchange rate of the USD moving from
a minimum of Rs. 54 to a maximum of Rs. 68. In particular, balances
on both the capital and current accounts turned negative during the
quarter July–September 2013.
An interesting unresolved issue in this context is the relationship between current account balance (CA) and capital account balance
(KA). The BoP equilibrium condition can be written as: CA + KA – ∆R
= 0, where ∆R is the change in forex reserves (with ∆R < 0 implying
reserve accumulation and ∆R > 0 implying drawdown of reserves). Of
course, with full flexibility of the exchange rate and in a reserve currency issuing country the importance of ∆R would be minimal. The typical
Indian case (for most years since 2000) may be characterised as: CA <
0, KA > 0 and ∆R < 0 with some two-way flexibility of the exchange
rate. The relationship between CA and KA is complex, and conceptually, there are elements of simultaneity in their relationship. Hence it
would be erroneous to ascribe the causality from CA to KA or the other
way round. While the exchange rate, global growth, domestic growth,
terms of trade and export and import restrictions can all influence CA,
the major determinants of KA would include factors such as country-
risk adjusted return, domestic and global growth, and restrictions on
inward and outward foreign investment.
The Indian case in this framework may be interpreted as follows. With huge amounts of liquidity sloshing around the globe as a
result of the policy of quantitative easing in the US, and the growth
rate in the Indian economy being reasonably high, considerable capital
inflows (both investment and borrowing) got attracted to India in the
quest for yield. Around that time (in 2009–10), with good growth and
a manageable CAD, the risk profile of India would also have appeared
reasonable to a typical foreign institutional investor. This gave a sense
of confidence (perhaps false and premature) to the Indian policymakers and prompted them to increasingly liberalize the import regime:
the policy towards gold imports over the past three years is an illustration in this regard. This led to widening of the CAD. When hints were
dropped about tapering, the Indian economy was not exactly doing too
well. With subdued growth, high CAD, and corruption and governance
issues, expectedly, the risks associated with the Indian economy could
not but appear higher in mid-2012 than in 2009 or 2010. Hence, in
such a situation, an FII needs to be compensated with a much higher
risk-adjusted return for continuing to invest in India. Thus, faced with
the hints of tapering and perceived higher risks in India, there were
massive capital outflows. With both CA and KA being negative, the
equilibrium was achieved through a combination of some drawdown of
reserves and a huge adjustment in the exchange rate.
But to begin with, we need to see what caused the outflows in
the capital account. In line with the literature already cited above, this
paper argues that both the tapering talks as well as India’s high and
persistent CAD are responsible for this sharp downward movement of
the INR vis-à-vis the USD.
Tapering Talks and Capital Outflows
It is well known that US monetary policy during a large part of
the first decade of the 21st century was somewhat easy.5 In particular,
when the sub-prime crisis hit the US economy in August 2007, the US
Fed responded quickly. Initially it cut the discount rate and started extended term loans to banks, and then, in September, lowered the target
for the Federal funds rate by 50 basis points. Thereafter successive cuts
amounting to a total of 325 basis points left the funds rate at 2 per cent
by April 2008. (Bernanke, 2012.) When the sub-prime crisis culminated
in the global financial turmoil in September 2008, the target for the
Federal funds rate was cut further by 100 basis points in October 2008.
Finally, by December 2008 the target rate was reduced to a range of 0
to 25 basis points, effectively its lower bound (Chart 3). The effective
rate till date continues to be at this level.
5
Taylor (2009) has shown that in terms of a perceived monetary policy rule (typical
Taylor’s rule), the actual policy rate fell well below what historical experience would suggest.
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Faced with the
hints of tapering
and perceived
higher risks in
India, there were
massive capital
outflows. With both
current account
balance and capital
account balance
being negative, the
equilibrium was
achieved through
a combination of
some drawdown of
reserves and a huge
adjustment in the
exchange rate.
47
Chart 3
Effective Federal Funds Rate and Size of US Fed’s Balance Sheet
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Faced with the
intensification of
financial crisis
Source:
US Fed.
and recessionary
tendencies, in
the latter part of
2008 and early
2009, the Federal
Reserve took
extraordinary steps
to provide liquidity
and support credit
market functioning,
including the
establishment
of a number of
emergency lending
facilities.
48
Faced with the intensification of financial crisis and recessionary tendencies, “in the latter part of 2008 and early 2009, the Federal
Reserve took extraordinary steps to provide liquidity and support
credit market functioning, including the establishment of a number of
emergency lending facilities”. (Bernanke, 2012.) The injections of such
liquidity, popularly called quantitative easing (QE), led to a bloating of
the balance sheet of the US Fed via a number of instruments/facilities
such as lending to financial firms and markets; rescue operations; holding of agency (like Fannie Mae or Freddie Mac) securities and mortgage
backed securities; and treasury holdings (of varied maturity). Consequently, the size of the US Fed’s balance sheet underwent a huge expansion from around USD 800 billion in mid-2008 to a little over USD 3
trillion in early 2013 (Chart 3). By the time Chairman Bernanke left the
US Fed in end-January 2014, the size of the balance sheet of the US Fed
surpassed the USD 4 trillion mark—an increase of nearly 390 per cent
over its mid-2008 level!
With exceptionally low interest rates (both at short and long
ends) as well as the huge amount of liquidity overflowing the US economy, short-term capital, which had dried up immediately after the crisis,
started flowing to EMEs. In fact, in the initial days of the QE era (QE1
and QE2), there were large net flows of capital to EMEs. (Subramanian,
2014; Chart 4.)6 But after 2010, the flows started declining and continued to do so before the Fed chairman hinted at possibilities of tapering
off of QE in May 2013.
6
This is at some variance with the findings of Fratzscher, Duca and Straub
(2013) that “QE1 policies during the first phase in 2008–2009 have triggered a substantial rebalancing in global portfolios, with investors shifting out of EMEs and other AEs
and into US equity and bond funds”. In contrast, “Fed policies during the second phase in
2010 (QE2) induced a portfolio rebalancing in the opposite direction, pushing capital into
EMEs”.
Chart 4
Net Capital Flows to Emerging Markets, 1990–2013
(% of EMs’ GDP)
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5.0%
QE Era
In percent of GDP
4.5%
4.0%
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3.5%
3.0%
2.5%
2.0%
By end-May
1.5%
1.0%
2013 the US Fed
0.5%
Source:
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0.0%
Subramanian (2014).
By end-May 2013 the US Fed dropped its first hint that in view
of the improving situation in the US, the pace of its asset purchase programme could be slowed down. On May 22, 2013, US Fed Chairman
Ben Bernanke made the following statement in his testimony before the
US Congress:
“Over the nearly four years since the recovery began, the economy has
been held back by a number of headwinds. Some of these headwinds
have begun to dissipate recently, in part because of the Federal Reserve’s highly accommodative monetary policy. Notably, the housing
market has strengthened over the past year, supported by low mortgage rates and improved sentiment on the part of potential buyers.
Increased housing activity is fostering job creation in construction and
related industries, such as real estate brokerage and home furnishings,
while higher home prices are bolstering household finances, which
helps support the growth of private consumption.” (Bernanke, 2013.)
This statement was largely interpreted by the financial market
players as a hint that the US Fed may soon start tapering off the size
of the bond-buying programme. Subsequently, Chairman Bernanke
indicated in as many words that the inevitable withdrawal of stimulus
would happen sooner than expected and said in a press conference on
June 20, 2013: “If the incoming data support the view that the
economy is able to sustain a reasonable cruising speed, we will ease
the pressure on the accelerator by gradually reducing the pace of purchases.” Thus, what was a hint on May 22 got confirmed with the June
20 statement.
These statements generated a spate of withdrawals from the
emerging economies; the more vulnerable (in terms of market-watched
indicators like CAD or fiscal deficit) a country was, more was the with-
dropped its first
hint that in view
of the improving
situation in the
US, the pace of
its asset purchase
programme could
be slowed down.
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Table 3
FII Investment Flows
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In contrast to the
earlier trends in FII
inflows, the three
months, June, July
and August 2013,
were characterized
by substantial
outflows in
both debt as well
(USD million)
Financial Year
Equity Net Investment
2006–07
2007–08
2008–09
2009–10
2010–11
2011–12
2012–13
2013–14 so far
Jan-13
Feb-13
Mar-13
Apr-13
May-13
Jun-13
Jul-13
Aug-13
Sep-13
Oct-13
Nov-13
Dec-13
Jan-14
Feb-14
Debt Net Investment
5,942
13,433
–10,712
23,353
24,295
9,012
25,832
10,243
4,096
4,142
1,913
1,184
3,772
–1,764
–986
–947
1,994
2,927
1,130
2,527
–13
420
Total Flows
1,3217,263
3,19316,626
492–10,220
6,56829,921
8,37132,666
10,06319,075
5,21531,047
–5,747
4,496
614
4,710
755
4,898
924
2,836
1,288
2,471
520
4,292
–5,366
–7,130
–2,111
–3,097
–1,379
–2,325
–1,260
734
–2,095
832
–784
346
863
3,390
2,021
2,009
2,555
2,975
Source:RBI.
as equity.
drawal and larger the consequent impact on its exchange rate. India
was no exception to this trend. In contrast to the earlier trends in FII
inflows, the three months, June, July and August 2013, were characterized by substantial outflows in both debt as well as equity on account
of FIIs; so much so that during the three months, aggregate outflows
amounted to nearly USD 12.5 billion, larger than the aggregate outflows of USD 10.2 billion during the crisis year of 2008–09 (Table 3).
An interesting feature of FII outflows during June–August 2013
was the predominance of debt outflows. In fact, even after flows on account of equity turned into inflows after September 2013, debt outflows
continued for three more months. Incidentally, this trend is in tune with
international evidence presented by Forbes and Warnock (2012) who
found: “Most episodes around the world—80% of episodes of sharp
changes in capital inflows (driven by foreigners) and 70% of episodes
of sharp movements in capital outflows (driven by domestics)—result
primarily from changes in debt flows.”(p. 17.)7
50
7
Market watchers widely believe that foreign capital flows to the Indian debt
market are dominated by five to six foreign banks. Thus, the possibility of herding behav-
As already noted, following the announcement by the US Fed
on postponing tapering off of asset purchase programmes, by September
2013, FII flows started coming back, primarily on account of the equity
market as the withdrawal on account of debt instruments continued for
three more months. The reasons are not far to seek. The Record of the
Federal Open Market Committee’s meeting of July 30–31 hinted that
withdrawal would be delayed and went on to say: “Almost all committee members agreed that a change in the purchase program was not yet
appropriate, and a few said that it might soon be time to slow somewhat the pace of purchases as outlined in that plan.” Finally, the FOMC
Statement released on September 18, 2013 put an end to all speculation
and stated the following categorically:
“The Committee will closely monitor incoming information on economic and financial developments in coming months and will continue
its purchases of Treasury and agency mortgage-backed securities, and
employ its other policy tools as appropriate, until the outlook for the
labor market has improved substantially in a context of price stability.
… Asset purchases are not on a preset course, and the Committee’s
decisions about their pace will remain contingent on the Committee’s
economic outlook as well as its assessment of the likely efficacy and
costs of such purchases.”
With such statements about postponement of the tapering off
of the QE in the US, the FIIs started coming back to India, the investments initially in the form of equity; debt flows took some time and
started coming back only from December 2013. These eased the pressure on the INR.
Were Weak Fundamentals Responsible for Capital Outflows?
But why was India affected by those apparently innocuous
statements of the US Fed? One of the asymmetries of the herd behaviour
of the FIIs is that when the going is good, often FII flows tend to enter
the emerging countries in a somewhat undifferentiated manner. 8 The
so-called “herd behaviour” is often based solely on “market sentiment”
rather than an objective assessment of market fundamentals. After
all, acquiring information can be costly in terms of time and money.
Moreover, for institutional investors, herding can emerge from either a
rational or irrational form of investors’ behaviour. In fact, when investors irrationally withdraw credits from otherwise stable and “healthy”
economies, initial capital flight could cause a reduction in the value of
assets, which in turn could cause a rational capital flight.9
iour tends to be more in the debt market that has fewer market players than in the equity
market, which has a far larger number of players.
8
There is large literature on herd behaviour; see Hirshleifer and Teoh (2001)
for a survey.
9
Lakshman, Basu and Vaidyanathan (2013) found some limited evidence of
herding in the Indian capital market.
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With statements
about postponement
of the tapering off
of the QE in
the US, the FIIs
started coming
back to India, the
investments initially
in the form of
equity; debt flows
took some time
and started coming
back only from
December 2013.
These eased
the pressure
on the INR.
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Finance
J u l y . 2 0 1 4
Apart from the
interest rate
differential and
liquidity conditions,
in a long menu
of market
fundamentals, the
two most watched
indicators are
current account
balance and fiscal
balance. By the
metric of CAD,
India’s progress
report was rather
alarming as it
touched nearly
4.8% by 2012–13.
52
But in case any crisis is brewing, while withdrawing financial
flows FIIs tend to differentiate between the countries in terms of their
market fundamentals. This trend was distinctly noticeable in Greece
when the market players suddenly started differentiating Greece from
other euro countries and the sovereign bond spread of Greece went
up to stratospheric levels. The present crisis is no exception to this
observed behaviour. Moreover, it has been empirically found that less
easy global financing conditions, with possibilities of rising interest
rates in advanced economies and low investor risk appetite, generally
see temporary tides of capital outflows. (Bluedorn & others, 2013.)
Apart from the interest rate differential and liquidity conditions, in a
long menu of market fundamentals, the two most watched indicators
are current account balance and fiscal balance.10 By the metric of CAD,
India’s progress report was rather alarming as it touched nearly 4.8 per
cent by 2012–13 or around USD 90 billion. The reasons are not far to
seek. India has a number of items, imports of which have increased substantially in recent years. Illustratively, both gold and oil imports have
gone up substantially and Indian exports in recent years have suffered,
reflecting the continuing recessionary situation in the global economy.
In fact, the trade deficit widened from USD 42.2 billion in the first
quarter (Q1) of 2012–13 to USD 50.2 billion in Q1 of 2013–14, mainly
on account of a sharp increase in gold imports. In particular, imports
grew by 6.0 per cent in Q1 of 2013–14 as against a decline of 5.7 per
cent in Q1 of 2012–13 with gold imports having almost doubled from
USD 9.2 billion in Q1 of 2012–13 to USD 17.9 billion in Q1 of 2013–
14. Besides, notwithstanding a fall of 5.7 per cent in international crude
oil prices (Indian basket) in Q1 of 2013–14 (year-on-year), oil imports
grew by 6.4 per cent. Persistence of high inflation in India could also
have played some role here.
The burgeoning CAD was financed by three major types of
capital inflows, viz., foreign direct investment (FDI), foreign portfolio
investment (FPI, in which FII is the dominant item), and short-term
debt. In 2012–13, while dependence on FDI came down, that on both
FPI and loans increased substantially (Table 4).
The current situation is clearer from the quarterly numbers
of these three components of foreign investment that the RBI releases
as part of the quarterly BoP statistics. The fall in FPI flows during the
quarter ending September 2013 was very substantial. With such large
outflows on account FPI, it is no wonder that the rupee came under
huge pressure (Chart 5).
For example, in the context of the exchange rate turmoil during June–August 2013 a recent market-watch report observed: “It is noteworthy that for a number
of emerging economies, including South Africa, Turkey, and India, much of the current
turmoil is also due to deterioration in economic fundamentals, primarily high current
account deficits, entrenched inflationary pressures, and deteriorating public finances.”
(Deloitte Global Economic Outlook, Fourth Quarter 2013, available at http://dupress.com/
articles/global-economic-outlook-q4-2013.)
10
icra bulletin
Table 4
Financing of Indian CAD
(USD billion)
Memo: CAD
Select Items of DForex
INR-USD Capital Account Reserves
Exchange Rate
FDI FPI Loans (Increase –/
Decrease +)
Money
&
Finance
J u l y . 2 0 1 4
2004–05 44.9315
–2.5 3.7 9.3 10.9 –26.2
2005–06 44.2735
–9.9 3.0 12.5 7.9 –15.1
2006–07 45.2849
–9.6 7.7 7.1 24.5 –36.6
2007–08 40.2410
–15.7 15.9 27.4 40.7 –92.2
2008–09 45.9170
–27.9 22.4 –14.0 8.3 20.1
2009–10 47.4166
–38.2 18.0 32.4 12.4 –13.4
2010–11 45.5768
–48.1 11.8 30.3 29.1 –13.1
2011–12 47.9229
–78.2 22.1 17.2 19.3 12.8
2012–13 54.4091
–88.2 19.8 26.9 31.1 –3.8
2013–14 (Apr–
Dec 2013)
60.0819
–31.1
20.7
–4.4
6.2
–8.4
Apr–June 2013
55.9491
–21.8
6.5
–0.2
3.6
0.3
July–Sept 201362.1278 –5.2 8.1–6.6–0.5 10.4
Oct–Dec 2013
62.0339
–4.1
6.1
2.4
3.0
–19.1
Source:RBI.
Chart 5
Foreign Investment Inflows
Source:RBI.
IV. Some Cross-Country Evidence
India was not alone in this bandwagon of currency pressure
during June–August 2013. Chart 6 (Panels a and b) depicts the exchange rates (with respect to USD) of the currencies of the four of the
five countries in the BRICS bloc along with Mexico, Malaysia and
Indonesia wherein the exchange rates have been normalized to May 22,
2013 (i.e., the date of the US Fed announcement on tapering) as equal
53
icra bulletin
Money
&
Finance
Chart 6
Exchange Rates (in USD) in Select Countries (May 22 = 1)
Panel a: China, India, Indonesia, and South Africa
J u l y . 2 0 1 4
With the exception
of China, the
currencies of
all the other
Panel b: Mexico, Malaysia, and Brazil
countries were on a
depreciating trend
over May–August
2013. Illustratively,
by September 1,
2013, both the
Indian rupee and
the Brazilian real
had depreciated
by more than
15% each since
the US Fed’s
announcement in
May 2013.
54
Source: Bloomberg.
to unity. As earlier, an upward (downward) movement will indicate a
depreciating (appreciating) exchange rate. With the exception of China,
the currencies of all the other countries were on a depreciating trend
over May–August 2013. Illustratively, by September 1, 2013, both the
Indian rupee and the Brazilian real had depreciated by more than 15 per
cent each since the US Fed’s announcement in May 2013.
Dividing the period of 2013 (till Nov 21, 2013) into three
distinct periods, viz., (a) January 1–May 22; (b) May 22–September
19; and (c) September 19–December 23, Chart 7 shows that during the
second sub-period almost all currencies had undergone large depreciation with the exception of the reserve currencies (pound sterling, euro
and yen) and the Chinese yuan. However, during the third period, there
was some improvement.
Are there any similarities between the countries experiencing
significant currency depreciation? To address this question, Table 5 re-
Chart 7
Cross-Country Exchange Rate Movements in 2013
icra bulletin
Money
&
Finance
J u l y . 2 0 1 4
Brazil, China,
Mexico and South
Africa are all
characterized by
significant CAD
as well as fiscal
Source:
Compiled from Bloomberg Data.
deficit—the two
indicators that are
ports the CAD and fiscal deficits (both as percentages of nominal GDP)
of six EMEs. Interestingly, Brazil, China, Mexico and South Africa are
all characterized by significant CAD as well as fiscal deficit (FD)—the
two indicators that are watched regularly by the financial market
participants as well as rating agencies to assess the attractiveness of an
investment destination in a rough and ready manner. It is thus no wonder that, when financial market players are faced with a tapering-like
situation and the possible consequent threat of drying up of liquidity,
countries with large CADs and FDs tend to experience capital outflows
and depreciation of the exchange rate.
A related issue is the nature of relationship between the CAD
and FD. International financial institutions like the IMF often propagate
the twin deficits hypothesis which states that budget deficits would lead
to the CAD (Kumhof and Laxton, 2009). On the other hand, in some
quarters, the “Lawson doctrine” (named after Nigel Lawson, the British
Chancellor of the Exchequer in Margaret Thatcher’s Cabinet during the
1980s) is quite popular. According to this doctrine, as long as the CAD
reflects the saving–investment imbalances of the private agents, it is not
alarming (perhaps in line with the Ricardian equivalence); however,
when it is accompanied by fiscal deficit, CAD is bad.11 Admittedly, this
11
When individuals, as in the Ricardian equivalence, maximise their utility,
subject to their inter-temporal budget constraints, and the economy’s investment-saving
watched regularly
by the financial
market participants
as well as rating
agencies to assess
the attractiveness
of an investment
destination.
55
icra bulletin
Table 5
Current Account Balance and Fiscal Balance of Some EM Economies
(% of GDP)
Finance
J u l y . 2 0 1 4
There is a mild
positive association
between CAD and
exchange rate
Country
Brazil
–1.7–1.5–2.2–2.1 –2.4–3.4
China
9.34.94.01.9 2.32.5
India
–2.3–2.8–2.7–4.2 –4.8–4.4
Mexico
–1.8–0.9–0.3–1.0 –1.2–1.3
Russia
6.34.14.45.1 3.72.9
South Africa–7.2–4.0–2.8–3.4 –6.3–6.1
Brazil
–1.4–3.1–2.7–2.5 –2.7–3.0
China
–0.7–3.1–1.5–1.3 –2.2–2.5
India
–10.0–9.8–8.4–8.5 –8.0–8.5
Mexico
–1.0–5.1–4.3–3.4 –3.7–3.8
Russia
4.9–6.3–3.4 1.5 0.4–0.7
South Africa–0.4–5.5–5.1–4.0 –4.8–4.9
General Government Net Lending/
Borrowing
&
Current Account
Balance
Money
2008200920102011 20122013
Source: World Economic Outlook Database, IMF, October 2013.
depreciation. In
fact, acute exchange
rate pressures were
felt especially by the
macroeconomically
vulnerable
economies, Brazil,
Indonesia, India,
and Turkey.
56
notion springs primarily from a philosophy of fiscal fundamentalism
and hence may not have much relevance. Of course, if the FD is largely
financed by sovereign borrowing in the global market (denominated in
a foreign currency) and is subscribed to by foreign entities, such FD can
be linked to capital inflows. To the extent surplus in capital flows (via
sovereign debt) can induce an economy to incur a CAD, the two deficits
can be interlinked.12 Fortunately, the sovereign debt in most of the six
countries in Table 5 is not alarming. The empirical literature has, however, mostly concluded that the link between the FD and CAD is weak
or non-existent. (Bussière and others, 2010.)
While the Chinese currency hardly faced any depreciation in its
exchange rate, in terms of recent movements (as captured by the trend
line) there is a mild positive association between CAD and exchange
rate depreciation. (RBI, 2013.) In fact, acute exchange rate pressures
were felt especially by the “macroeconomically vulnerable economies”,
Brazil, Indonesia, India, and Turkey (Chart 8).13
Thus, significant CADs accompanied by dependence on fickle
portfolio flows could have made India vulnerable to external shocks.14
imbalance is an outcome of inter-temporal optimisation of such individuals, one need not
worry about current account deficits.
12
Parenthetically, one may note that in some sense, this is the situation in a
number of Euro area crisis countries.
13
These countries have been included as part of a group of countries named
“Fragile Five” by the investment bank Morgan Stanley in a recent internal note; see
https://www.morganstanley.com/public/Tales_from_the_Emerging_World_Fragile_Five.pdf.
14
Reportedly, Moody’s Analytics in a recent report (entitled “How US Monetary Tightening Affects Asian Markets”) had remarked that: “India and Indonesia are the
most vulnerable to capital outflows because of high reliance on external funding.” (The
Hindu, September 23, 2013, available at http://www.thehindu.com/business/Economy/
india-most-vulnerable-to-capital-outflows-moodys/article5160832.ece.)
Chart 8
Current Account Balance/GDP and Extent of Currency Depreciation/Appreciation
icra bulletin
Money
&
Appreciation (–) / Depreciation (+)
Finance
Current account balance
Source: Subramanian (2014).
V. The Indian Policy Initiatives
Faced with capital outflows, the pressure on CAD and the associated exchange rate depreciation, the Indian authorities initiated a
number of measures, to which we now turn.15
RBI Intervention Strategy
The first question that comes up in this respect is: How much
did the RBI intervene in the forex market to arrest the fall of the rupee?
While providing a policy buffer, forex reserves could allow a country to
intervene in such conditions.16 However, the RBI’s direct intervention
in the forex market was somewhat limited; during the months of June–
September 2013, the total extent of intervention of the RBI was a little
above USD 14 billion (Chart 9). After all, as on May 31, 2013, India’s
total forex reserves amounted to USD 288 billion, of which foreign
currency assets of USD 259 billion could have been used for market
intervention. (Seshan, 2014.)
The reason appears to be that, given the compulsions of the
impossible trinity (whereby a country cannot have an independent
monetary policy, a fixed exchange rate and prefect capital mobility at
the same time) and India’s macroeconomic configuration, chasing any
illusive exchange rate could have been futile. After all, such a strategy
would have meant either presence of an elaborate set-up of capital
controls or huge forex reserves, both of which India did not have.
See Sinha (2014) for a discussion on these measures.
Reportedly, Brazil announced a USD 60 billion currency intervention programme in August 2013, involving swaps and repurchase agreements with businesses requiring dollars. Turkey’s central bank is reported to have sold USD 6–8 billion in foreign
currency auctions since June 2013. (RBI, 2014.)
15
16
J u l y . 2 0 1 4
Given the
compulsions of
the impossible
trinity and India’s
macroeconomic
configuration,
chasing any illusive
exchange rate could
have been futile.
After all, such a
strategy would
have meant either
presence of an
elaborate set-up
of capital controls
or huge forex
reserves, both of
which India did
not have.
57
Chart 9
Net Purchase/Sale of Foreign Currencies by RBI (USD million)
icra bulletin
Money
&
Finance
J u l y . 2 0 1 4
The RBI
implemented two
key policies to
lessen the pressure
on the exchange
rate. First, the RBI
opened a forex
swap window to
meet the entire daily
dollar requirements
of three public
sector oil marketing
companies.
Second, the Indian
and the Japanese
governments have
expanded their
bilateral currency
swap arrangement.
58
Source:
RBI Bulletin, various issues.
Other Measures
Instead of intervening heavily to defend the rupee, the RBI implemented two key policies to lessen the pressure on the exchange rate.
First, the RBI opened a forex swap window to meet the entire daily
dollar requirements of three public sector oil marketing companies (viz.,
Indian Oil, Hindustan Petroleum, and Bharat Petroleum) with effect
from August 28, 2013. Under the swap facility, the RBI undertook sell/
buy USD-INR forex swaps for fixed tenure with the oil marketing companies through a designated bank. This swap facility continued for the
next three months and was withdrawn on December 2, 2013 after the
rupee stabilized to a large extent. Second, the Indian and the Japanese
governments have expanded their bilateral currency swap arrangement
from USD 15 billion to USD 50 billion to impart stability to the forex
situation.
A number of other policy measures were also initiated to
augment capital inflows. These included: exemption of incremental
FCNR(B)/NRE deposits with a maturity of three years and above from
cash reserve ratio/statutory liquidity ratio (CRR/SLR) requirements;
exclusion of the incremental FCNR(B)/NRE deposits from adjusted net
bank credit for computation of priority sector lending targets; liberalization of FDI norms through review of limits; raising of the overseas
borrowing limit of banks from 50 to 100 per cent of the unimpaired
Tier I capital (with the option of swap with the RBI); and permitting
of borrowers to avail themselves of external commercial borrowings
(ECBs) under the approval route from their foreign equity holder company for general corporate purposes.
Finally, two major steps were taken to curb gold imports—one
of the major factors responsible for increasing India’s import bill. First,
the RBI rationalized gold import rules whereby under the new norms,
all banks and authorized agencies would have to ensure that at least
20 per cent of the imported gold was made available for exports and a
similar amount retained with the customs. Second, import duty on gold
was increased twice; initially, on June 5 the duty was raised to 8 per
cent from 6 per cent, and then to 10 per cent on August 13.17
All these measures went a long way in containing the CAD and
easing pressure on the rupee. With slowdown in imports (particularly
gold import) and improvements in global trade, India’s trade deficit
went down for the sixth consecutive month in December 2013. Following the shrinking of the trade deficit, the CAD declined from 4.9 per
cent of GDP in Q1 to 1.2 per cent of GDP in Q2 of 2013–14. The RBI
expressed the optimism that the full year CAD “is likely to be contained within the sustainable level of about 2.5 per cent of GDP”. (RBI,
2014a.)
VI. Concluding Observations
The paper has examined the recent depreciation of the INR
against the USD during June–August 2013. The proximate factors
triggering the episode were the US Fed’s announcements of tapering off
QE in end-May 2013 and the consequent withdrawal of capital flows
(primarily on account of portfolio outflows, both debt and equity). India with its somewhat fragile macroeconomic fundamentals, as reflected
in its high and increasing CAD (financed mostly by foreign portfolio
inflows), was affected by these adverse global developments. In fact,
India’s was not an isolated instance in this respect: the exchange rates
of various other countries with similar macro fragility also depreciated
sharply following the QE tapering off related announcements. The rupee started recovering following the introduction of a number of measures for reducing CAD coinciding with the announcement of the US Fed
in September 2013 to the effect that the proposed tapering off would be
deferred for the time being. Thus, as in Agatha Christie’s Murder on the
Orient Express, the responsibility for the instability in the forex market
in India during the three months could not be pinned down to a single
villain. While the US Fed’s tapering talks were no doubt the initial trigger, the dependence on volatile foreign investment and short-term debt
to finance an increasing CAD (along with the deterioration in various
other macroeconomic indicators watched by market players) constituted
compelling reasons for the withdrawal of foreign institutional investors
from India.
Apart from this lesson, the episode underscores the flip side of
opening up the financial sector. At the risk of being accused of pontificating, one may state that financial globalization is a double-edged
sword: it brings capital in good times and takes it out in bad. It is a
matter of concern that the Indian economy was not prepared for such
17
Earlier on January 21, 2013 the government raised gold import duty by 2
percentage points to 6 per cent.
icra bulletin
Money
&
Finance
J u l y . 2 0 1 4
India’s was not an
isolated instance:
the exchange
rates of various
other countries
with similar macro
fragility also
depreciated sharply
following the QE
tapering off related
announcements.
59
icra bulletin
Money
&
Finance
J u l y . 2 0 1 4
60
bad times. And it is little wonder that the heavy dependence on foreign
capital proved costly. Incidentally, such dependence on fickle sources for
financing CAD is not new. For instance, during the 1980s, India developed a great dependence on non-resident Indian (NRI) deposits, thereby
increasing its vulnerability to external shocks (Rakshit, 2009), and the
crisis of 1991 only got worse with the withdrawal of such deposits.
Does this mean that the policymakers forgot the earlier crises? Also, in
a larger context, have we been oblivious of Keynes on internationalization? In his words: “Ideas, knowledge, science, hospitality, travel—these
are the things which should of their nature be international. But let
goods be homespun whenever it is reasonably and conveniently possible, and, above all, let finance be primarily national.”18 These are
however broader issues and beyond the scope of the present paper.
18
Keynes, J.M. (1933): “National Self-Sufficiency”, The Yale Review, Vol. 22,
no. 4, June 1933, available at https://www.mtholyoke.edu/acad/intrel/interwar/keynes.htm.
Appendix
icra bulletin
Money
Comparison between 1991 Crisis and the June–August 2013 Exchange Rate Debacle
Variable
1 Global prices Gulf Crisis (1983–84 to 1992–93)
&
Finance
Current Situation (2003–04 to 2012–13)
Oil and commodity prices went up and Global commodity and crude prices have been
J u l y . 2 0 1 4
became more volatile after the first Gulf War. more or less stable during the last few years.
2 Domestic Inflation rate was more volatile and
inflation it was 7.1% in 1992–93. Inflation, though high during the last three
years, is declining and stands at 5.7% as of
2012–13.
3
Growth is subdued at 6.9% and will decline,
going by the current trends.
Domestic GDP growth Growth picked up from 1992–93 because of
the many economic measures initiated. 4 Foreign ex-
In 1990–91, at one point in time, it was only
change reserves USD 1 billion, just enough to finance barely two weeks’ imports. Foreign exchange reserve is at USD 279 billion
as of July 29, 2013, sufficient for 6.8 months’
imports.
5 CAD CAD became unsustainable because global CAD has become unsustainable because of
commodity prices increased, pushing up increasing import of petroleum products,
interest costs and amortization, with a drying gold and many other luxury items.
up of remittances, especially from Kuwait. 6 Trade deficit Export income was able to meet 78% of import bill, which rose mainly because of an increase in global oil and commodity prices. Exports can pay for only 61% of imports
mainly because of higher oil and gold imports.
7 Net invisibles Net invisibles declined from USD 3.5 billion in 1983–84 to USD 1.9 billion in 1992–93. Able to cover only 35% of trade deficit. Net invisibles position is not bad at USD 107.8
billion and is able to cover about 55% of trade
deficit.
8
Debt payment Debt payment increased and was equivalent
(net income) to 88.8% of remittances in 1992–93. Debt payment has increased but is only 33.3%
of remittances as of 2012–13.
9 Remittances
Average growth was 4.7% during the period and the figure was USD 3.9 billion. Average growth has been 12.9% during the
period and the figure is USD 64.3 billion as
of 2012–13.
10 Net capital receipts
Net capital receipts have been more than
sufficient to defray the CAD and thus there
have been additions to the foreign exchange
reserve in most years except 2008–09 and
2011–12.
Net capital receipts were not sufficient to
defray the CAD; hence the increasing recourse to drawdown from foreign exchange reserve and withdrawals from IMF to pay for the deficits. 11 Foreign Foreign investment was insignificant during
investment
the period. Foreign investment flows have been sufficient to
cover the deficit and have added to foreign
exchange reserves. However, overdependence,
especially on volatile portfolio investments, is
dangerous.
12 NRI deposits
NRI deposits are 0.8% of GDP as of 2012–13.
Deposits were 0.1% of GDP in 1991–92 and rose to 0.8% by 1992–93. 13 What ahead?
Improved after 1992–93 as the government adopted different economic and reform measures to improve the overall health of the economy. Present position is much better than that in
1991. Hence for the present recourse to IMF
is not warranted. Measures that would constrict
imports, like imposing higher customs duty on
gold, while taking adequate measures to attract
the more stable foreign direct investment can
help in overcoming the present difficulties.
Source: Krishnaswamy and Kanagasabapathy (2013).
61
icra bulletin
Money
&
Finance
J u l y . 2 0 1 4
62
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