The rupee, which has been under relentless pressure over the past few weeks, came very close to breaching the 60-mark in inter-bank trading during the day on Thursday, but closed just a shade above at the end.
A breach of the 60-mark would — for lay people and some professionals alike — be a major psychological blow, which no amount of explanations from government spokespersons will help mollify. Neither will the significant decline in the exchange rates of practically all emerging market currencies be taken as a mitigating factor. Indian stock markets, like their counterparts in many developing countries, already displaying a weak trend, slumped on Thursday. The Sensex and the Nifty ended the day sharply lower by 526 and 166 points, respectively, compared to the previous day closing rates.
Behind the extreme financial market volatility across the globe has been a much anticipated announcement on Wednesday by the U.S. Federal Reserve on the future course of the of the monetary policy. After a two-day review, Fed Chairman Ben Bernanke announced a gradual withdrawal of the extraordinary monetary stimulus programme, which ensured extremely low interest rates in America but simultaneously released very large sums of money, some of which found its way to India and other emerging markets in search of higher return than available at home.
The fear in India and other emerging market countries has been that with the phasing out of the stimulus, much of the money, which has been invested in the equity and debt markets, will flow back to the U.S. Some of this has already been happening recently. In the past month, foreign investors sold debt worth Rs.18,345 crore, and equities of an estimated value of Rs.1374 crore.
Global uncertainty, which in recent times has invariably been attributed to the likely posturing by the U.S authorities, has been cited as the principal reason. But even a quick glance at the U.S Fed announcement raises the question as whether the fears of the financial sector have become self-fulfilling.
The Fed has been addressing domestic concerns — the stimulus (quantitative easing as it is called) was meant to revive the U.S economy; its termination will again depend on domestic factors. Quite significantly, the Wednesday announcement was by no means pessimistic. In fact, the authorities appeared increasingly confident in the durability of economic growth. It is this confidence that is behind the decision to pull back the stimulus later this year, but in a gradual fashion. The withdrawal of the stimulus would be linked to the U.S economy reaching definite sign posts such as the unemployment rate coming down to 7 per cent (which is expected by the middle of next year). Altogether, the official view is that growth prospects of the U.S. economy have improved.
The point is that a strengthening U.S economy ought to be a positive factor for India and its markets. But the exactly opposite reaction is most certainly due to the fear — partly materialised — of short-term flows fleeing the markets, dragging down the rupee and stock indices, which brings us to the serious weakness of India’s external sector and its abject dependence on short-term flows to fund the balance of payments. The Indian economy has been slowing down perceptibly.
Short-term flows from the U.S. might have camouflaged the weaknesses. The possibility of these flows reversing might have been the trigger for the sharp declines in the markets.