Chasing India’s currency problem.
It seems that India is constantly a step behind in the present investor confidence plunge in the country.
With a lack of control over the falling currency, investors are leaving the country as capital outflows increase.
The efforts by the central bank to curb the depreciating currency since July have included tightening the money supply, restricting currency derivatives, and curbing gold imports. Gold is being seen as the safe investment in India right now and the rise in the demand corresponds with a sharp decline in the value of the rupee.
The decline of the Rupee is resulting in a flight of Foreign Direct Investment (FDI).
The efforts were weak and ineffective and so now, the Reserve Bank of India (RBI) is limiting Indian investments from going out of the country, which will further dampen the demand for dollars. The cycle is becoming more and more vicious as the falling rupee leads to an exodus of FDI in the country which puts downward pressure on the currency itself. Over the last two years, the rupee has fallen by more than 25 percent.
The recent move has already made some industry experts call for capital controls; however, at this point the ability to invest outside of India, is only restricted to Indian investors rather than foreign investors — which is seen as a half measure.
The recent growth in the local industry of India and the export of many of its operations has slowly led to the crisis at hand. The strategy of the companies to invest outside its border and investing in terms of market growth, expansion and setting up operations outside the country caused the steady decline in the currency. The market has responded positively to the recent move with a rise in the currency forwards but the long term impact will have to be seen to reach any certain conclusion.
The rupee has already lost more than 10 percent of its value since January hitting an all-time low of 61.8050 per dollar on 6th of August. The plunge accelerated in May as many of the investors withdrew from equity and bond markets. This makes controlling the drop the top priority for the RBI in order to gain back the investors and the policy changes are signaling that serious thought is being put in to making that happen. The problem arrives at balancing between free market and capital controls which can deter foreign investors from investing again and further harm investor confidence.
The dilemma faced by India is classic economic theory. It states that no country can balance free capital movement, stable currency and independent economic policy all at the same time. They have to choose between two and let go of the third.
In order to get more capital into the country, the interest rates have been increased twice in the recent past which would have led to higher demand in the rupee. In addition, the rush into gold market was limited by imposing duties on the import of gold and gold storage was mandated into government owned warehouses which would limit the trading into the gold market.
As gold is tied to the dollar, a rise in demand leads to a higher supply of the rupee depreciating its value. Experts believe that these short term solutions will not lead to major changes and that investment opportunities should be made more attractive into India in order to curb the constant decline in the currency. Capital inflows will have to be brought back in order to support the currency which was in place before.
The current crisis mirrors the rising current account and budget deficit of 1990s where the rupee fell by more than 30 percent between 1991 and 1992. Back then an emergency loan was taken from the IMF of USD 2.2 billion to purchase gold as collateral for the reserves. The loan aided the country to open its borders to international investment which caused the country to first see a slowdown in its GDP growth in 1992 but then a rise in its GDP since.
India’s economic growth is expected to slow in the coming years and the rise in recent interest rates will weigh heavily on local industries, further decreasing the growth potential over the next few years. With a current account deficit, there is an expectation that things will get worse before they get better and the country will have to sell its gold reserves to sustain the economy.
Serious measures are required to encourage more investment in the country and it might be that the limitation on investments that India does have, might need to be abolished in order to lead to long term growth of foreign investment.