Till barely a month ago, industry was pleading with the Reserve Bank of India to end the high interest rate regime that has brought its growth to a standstill and caused a wholesale flight of savings from the share market into land and gold. So the most puzzling feature of its reaction to the RBI’s July 30 decision to keep policy interest rates unchanged has been its silence.
Dire threat
This curious reversal begins to make sense only when seen against the backdrop of the dire threat the Indian economy now faces. This is the imminence of a foreign exchange crisis that can wreck the economy in much the same way as the 1990-91 crisis almost did. The parallels between 2013 and 1991 are striking. At close to $400 billion, India’s foreign debt is a third larger than its reserves. The short-term component of the debt has risen sharply in the last two years. Partly because of this, the servicing of the debt will absorb a staggering 59 per cent — $169 billion — of the country’s total reserves in the coming 12 months. To this must be added a deficit in the current account balance of payments that had risen alarmingly to $88 billion — 4.8 per cent of the GDP — in 2012-13. It is no surprise, therefore, that hedge funds abroad have begun to circle the Indian economy, sensing the possibility of another “kill.”
A foreign exchange crisis now will be far more damaging than the crisis of 1991. In 1990, when Iraq’s invasion of Kuwait triggered the crisis, industry was growing at 12.8 per cent. What is more, Indian companies had raised no capital abroad. So the foreign exchange crisis did not threaten them directly with insolvency. All they needed to resume growth was a renewed supply of foreign exchange and the freedom to grow.
Today, industry’s growth rate has been below one per cent for 20 months. So it has little of the resilience that it had in 1992. But what is giving India’s entrepreneurs nightmares is the foreign debt they have contracted since 2006-07. The outstanding amount is now $140 billion and the rupee’s fall is making this increasingly difficult to service and repay. What is worse, all but a fraction of the debt has been incurred by around 100 large Indian firms that also account for close to 70 per cent of the domestic credit extended by commercial banks. If a rising debt service burden abroad forces them into insolvency, it will create a domestic liquidity crisis that will bring bank-lending to industry to a halt.
For the embattled firms, the only way out will be to sell their prize assets. Since there will be many sellers and few buyers, this sale will take place at bargain basement prices and, as happened in Thailand and Indonesia in 1998-99, foreign companies will cherry-pick the best of them. Suzlon’s attempts to stave off bankruptcy by selling three quarters of its Indian assets, and Jet Airways’ agreement to sell Etihad Airways a controlling share in the company are therefore only harbingers of the flood that will follow.
This catastrophe can be averted only by reversing the outflow of capital from the country. For that to happen, foreign institutional investors have to start believing once again that they can make money by investing in the Indian economy. They will do so only when share prices begin a sustained rise. For this to happen, there must be a revival of demand and investment in the economy. And this, in turn, will only happen if the RBI brings interest rates sharply down.
Had the RBI cut rates two years ago when the rupee was at 44.15 to the dollar and foreign exchange reserves were comfortably in excess of debt, FIIs would not have needed much convincing. But today the government needs to combine a cut in interest rates with steps to bring down the current account BoP deficit (CAD) sharply, and reduce the private sector’s exposure to debt. For only then will investors feel reassured that the rise in imports that will accompany a revival of demand and investment will not tip India over into a balance of payments crisis.
Need for decisive action
The need of the hour, therefore, is coordinated and decisive action on several fronts. But the government’s responses have been uncoordinated and almost entirely reactive. Over six weeks, the government and the RBI have quadrupled the customs duty on gold and limited its imports to five times the export of ornaments and jewellery; eased the entry of foreign direct investment into 12 sectors and raised the interest rate on bank borrowing from the Marginal Standing Facility by two per cent.
But the RBI has refused to lower interest rates and Delhi has remained a helpless spectator. It is no surprise therefore that confidence in the government’s capacity to manage the economy has seeped away and speculative pressures on the rupee have mounted steadily.
In June, $9 billion of foreign capital left the equity and debt markets. Since then, the pessimism abroad about India’s future has deepened. One indicator of how deep it runs is that on July 30, when the RBI again did not lower the interest rates, commercial banks borrowed Rs 26,500 crore — $4.25 billion — from the Marginal Standing Facility at 10.25 per cent to enable their depositors to buy dollars. As the French bank, Credit Agricole, put it, “the situation in India is quickly turning into a vicious circle. […] Higher rates […] lead to higher debt-servicing cost and worsening fundamentals (such as slackening demand and higher investment risk), which are the root cause of the rupee’s weakness.” Not surprisingly, the rupee ended almost 3 per cent lower in a single day.
Unsuccessful attempts
Delhi’s attempts to attract FDI have been equally unsuccessful. On the very day that it eased FDI entry in 12 sectors of industry, Posco, the Korean steel giant, pulled out of its 6 million tonne steel plant venture in India. Arcelor Mittal followed a day later. Walmart has yet to invest a single dollar in the retail sector.
India still has one shield against catastrophe — the rupee’s lack of full capital account convertibility. By slowing down the fall of the rupee it is once more buying the government time, as it did in 1997, to turn the economy around. If the government acts decisively now, it can do so with relative ease. India is already well on the way to reducing the CAD, for the import of gold has fallen from $7 billion in April and 8.4 billion in May to $2.45 billion in June and about $4 billion in July.
Since gold and jewellery exports totalled $70 billion last year, the pegging of gold imports to jewellery exports is likely to bring future imports of gold from the current 800-1000 tonnes to between 300 and 400 tonnes a year. This will cut the import bill by $25 billion to 30 billion.
There has also been a seven per cent drop in the price of oil and an 11 per cent drop in those of industrial inputs since January. This should shave another $ 15 billion off the import bill. Exports also seem set to rise by about 10 per cent. India does not therefore need to do much more to limit the CAD to 2.5 per cent of the GDP.
Another measure that can ease the pressure on the rupee is the closure of the automatic approval route for external commercial borrowing, till stability is restored. This will halve new borrowing and give the RBI more room for manoeuvre.
But all of these will prove to be temporary palliatives if the RBI does not lower interest rates, not two months from now as it has ‘half-promised’ but within days. For till FIIs sense the possibility of making money on rising share prices once again, the pressure on the rupee will continue to grow until it overwhelms the puny defences the government has set up.
(The writer is a senior journalist)
