From being strong and synchronised a year ago, global growth has suddenly become very divergent. This has had a bearing on the Indian rupee, leading to a sharp depreciation. Economist Sajjid Z Chinoy explains to P Vaidyanathan Iyer and select readers how this happened, and what could follow.
Dr Chinoy is chief India economist at J P Morgan and also covers South Asia. Earlier with IMF and McKinsey & Co. Recently appointed adviser to 15th Finance Commission, he has served on RBI expert committee on monetary policy framework, and was a consultant to government-appointed FRBM review committee.
On the global events leading to depreciation of the rupee
Just a year ago, we were talking about how the global environment is in a Goldilocks phase where you had strong, synchronised growth. The US is in the 10th year of its expansion. Think of a business cycle and multiply it by 10 for a human life — so, for the US to be in the 10th year of expansion is tantamount to somebody being 100 years old and still growing, and growing at the fastest pace in many years. Just a year ago, the sense was that there will be global synchronised growth — capital flows are flooding into emerging markets, the rupee is going to go high up. What has changed? We went from an environment of convergence — where the US is doing well, Europe is doing well, Japan is doing well, China surprised for six successive quarters — to divergent growth. If you are on a highway and you are all driving at the same pace, there is no tension. If you are all accelerating at the same pace, there is no tension; if you are all slowing at the same pace, there is no tension. Tension comes when there is divergence in speed. So in 2018, the US is on a full-blown sugar rush. At this stage of the business cycle, to grow at 4% in the second quarter, 3.5% in the third quarter, is much above potential growth.
The US is doing much above potential; Europe has hit a pothole and now it is looking like a ditch where for three successive quarters it has underperformed. So, suddenly that convergent growth has become very divergent. The US is doing very well, Europe is underperforming and China, which was already slowing as a policy-induced re-balancing, is slowing further because of the worries of the trade war. Whenever there is divergence in growth, what happens is people get worried, and there is a flight to safety. So capital flows from the periphery back to the centre, which is the US, and the dollar strengthens. When the dollar strengthens, any emerging market with a dollar liability — Argentina, South Africa, Turkey — comes under stress. So the root of this entire problem is divergence in global growth. The US had a large fiscal stimulus so late in the business cycle, which no economist would really recommend — it is like running a marathon and in the last 5 km you consume coke and you have the sugar rush and you are bursting along, but that’s unsustainable. What you are seeing is two quarters of very strong growth, our sense is that in the next two quarters growth slows sharply. The stress is… The US Fed keeps hiking rates, because the US economy is doing well. By their own estimates, they have three more rate hikes just to reach their definition of neutral. Policy in the US is accommodative at a time when the unemployment rate is at a 40-year low. They need to be actually in restrictive territory, but they are accommodative. So they have got three more hikes to get to neutral, if not more. And at the same time the US is raising rates, China is easing policy. And that’s where the global stress is emanating from. We will talk a lot about the rupee, how to judge it, but this is not a domestically induced trigger. These triggers are purely, largely global. There are imbalances locally which exacerbate some of the stress. That is the crux of why 2018 is so different from 2017; the convergence then has turned to divergence now.
On the impact of global crude oil prices on the Indian rupee
India is very sensitive to oil prices; most of the emerging markets are very dependent on imported oil. Oil had collapsed [earlier], and India got this huge terms of trade shock. As the oil prices went down, the windfall to the Indian economy was 3% of GDP , which was very large, and most of it got spent. Therefore, three years ago when global growth was slowing, Indian growth accelerated past 8%. People were wondering why India was doing so well when global economy was slowing. A lot of it was because of the huge terms of trade shock from oil. When that happens, typically economic theory would say, you spend this terms of trade shock. The trade-weighted exchange rate — the real exchange rate — should actually appreciate. Many people look at the dollar-rupee rate — and that may be important… for the economy as a perspective, that’s not what matters. If you look at all your trading partners, and look at those bilateral trade exchange rates, and take a weighted average of that, that’s what matters for the economy as a whole. The trade-weighted, real exchange rate appreciated 20% between 2014 and early 2018. People will look at the dollar-rupee rate and say, “Well it was 65 then, it’s 69 now, things were even-steven”. It wasn’t. What was happening that under the radar, the exchange rate on a trade-weighted basis was getting progressively stronger, which was not visible in the dollar-rupee rate. That, in my view, hurt Indian competitiveness… The stronger rupee — in trade-weighted terms, it was much stronger —actually hurt Indian competitiveness. There is a phrase for this in economics, it’s called the Dutch disease.
In 1961, Holland gets a huge windfall of gas deposits, capital comes flooding in, they spend that windfall, the exchange rate appreciates, and the rest of the Dutch economy becomes uncompetitive. A little bit of the Dutch disease has happened to India. Our windfall is from lower oil — we spent it, the exchange rate went up, and that made the underline current account less competitive. Which is why some degree of rupee depreciation is healthy, is necessary, will help the Indian economy. After 20% appreciation in trade-weighted terms, we have now weakened by 9%. When I hear the rupee is the worst performing in Asia, it is misleading, because our comparative set is our trading partners — compared to them we were 20% stronger; we have only given back 9% of that. To come back to oil, because the underline current account is getting worse, when oil prices jump up, the headline number takes a shock. So the current account of 1.9% last year is tracking 3% of GDP this year — 3% is hard to finance at the best of times, especially when global financial conditions are tightening and US rates are going up.
On how far rupee depreciation should be a cause for concern
There was very little that policymakers could do on the way up. That 20% depreciation was despite the fact that RBI was buying dollars like there’s no tomorrow. That was the equilibrium response to the terms of trade shock. Now the exact opposite is happening. Oil prices have gone back up, and terms of trade have become less favourable, and this is the equilibrium response to that. I think that there are two principles policymakers should follow. One is not to panic, because I firmly believe that this is not like 2013. Our starting points are much better. Add up the fiscal deficit and the current account deficit to get the concept of twin deficits. The twin deficits have gone up in the last two years, but they are still much lower than what they were five or seven years ago. The second is, our buffers are much higher — by all measures of adequacy, the reserves are sufficient. If it is a shock, you have got to spread the adjustment across different instruments. Some of the shock absorbers should be the rupee, some have to be drawing down reserves, some have to be higher interest rates, some have to be tighter fiscal policy. As long as you do this, you are spreading the adjustment across… I think they have handled it very well.
On a theory that market rigging is running the rupee down
Our market is too deep and too wide and spread across too many countries, for anyone to rig it in my view. The fact that this has happened in tandem with every other emerging market on the globe, and the fact that it is reflecting imbalances — not insurmountable imbalances — tells me that this has to be understood: we are running a balance-of-payments deficit, which simply means that the demand for dollars is less than the supply of dollars. When demand exceeds supply, prices go up. I don’t think you can have a seven-month depreciation in a market as deep as India (there are both onshore and off-shore markets) that it can — we are not in the 70s-80s — that it can be rigged by anybody. It is philosophically important to separate two phenomenons. One is “rigging of the markets”. But can the market get into a self-fulfilling spiral? Yes, it can. Everybody believes that the rupee is going to weaken. Then exporters will basically stop hedging because they believe that the rupee tomorrow is going to be weaker than today; importers will front-load; the imbalance gets worse; the rupee weakens. Everybody says, “I was right, let me do more of the same”. That’s a self-fulfilling spiral. Which is why it is good to have two-sided volatility, to keep markets honest. It’s important once in a while for central banks to intervene to push the rupee the other way, but exporters can’t say this is a one-way street. It is important to anchor rupee expectations, so that they don’t get unhinged and you don’t get caught in a self-fulfilling spiral. That is a legitimate concern which policy should address.
On exports not doing well in the last few months
It’s been a much longer phenomenon. In the last six years, India’s exports have fallen very sharply. The export sluggishness has predated the last six months. It is global in the sense that this is what de-globalisation is — global growth picked up a little bit but exports have not picked up in tandem. There is a worry about de-globalisation. I would argue, in India’s case, it has been compounded a little bit by the stronger rupee. In India, there is a lot of dispute about the elasticity of exports to the rupee. A lot of people feel exchange rates don’t matter — whether the rupee depreciates or appreciates by 10%, it doesn’t hurt exports. Now it’s undoubtedly true that exports are driven largely by global growth; most empirical studies find that. But what we found in our paper in July was that, in a long enough horizon, there is a very strong relationship between a trade-weighted real exchange rate and India’s non-oil exports. Every 1% increase in the exchange rate hurts export volumes by 1.3%, which is very large, but over a period of time — over six, eight months down the line. All else being equal over the next year, you will see exports picking up. The complication is, even as the exchange rate is depreciating, will global growth prospects get worse next year, which will hurt exports? Then people will say, “I told you so, the rupee depreciation meant nothing”. But you have to disentangle these effects; you have to look at the impact of the rupee depreciation, holding global growth constant. My suspicion is, there is an elasticity there.
On depreciating Asian currencies and trade wars affecting India
The two risks to monitor — one is of course oil prices, which are hard to forecast — are how quickly will the US Fed move, will there be one rate hike every quarter for the next six quarters, what does that do to the dollar; and what happens to the trade war with China. If you look at India’s trade deficit and you strip out oil, half that — 50% to 60% of the trade deficit — is actually with one country, China. The bilateral trade deficit has gone up, so we need to be particularly sensitive to how the rupee is doing versus the CNY [Chinese yuan]. Our sense is that the trade war is going to get worse before it gets better. US and China economists believe that the base case is that on January 1, the US imposes a 25% tariff on all Chinese imports. That will be massive — politically, it is the most popular item on President Donald Trump’s agenda. If you do that, estimates are that Chinese growth will get affected by a full percentage point, which will take it much below 6%. But we know Chinese policymakers don’t want that to happen; they want a soft landing. China economists say you will see a pretty large policy response coming from China. There’s been a fiscal response, and there will be a monetary response. The CNY has weakened by 9% this year, from April to now. And the base case is that CNY goes to 7.5 against the dollar next year [6.95 as of November 14]. That is the best antidote to putting on tariffs — the Chinese policymaker depreciates. Why does this matter so much? Because if the Chinese currency is depreciating, that has a spillover effect on all the countries in the region that are either part of the value chain, or are competing with China. In India’s case, we have to be particularly sensitive because if the Chinese currency is depreciating and the rupee is stable, then the rupee becomes expensive vis-à-vis CNY. That means all imports from China will become 10-15% cheaper, which is the last thing we want. The balancing act for Indian policymakers will be, how do you keep a modicum of stability so that you don’t have a self-fulfilling spiral in the foreign exchange market? At the same time, how do you keep pace with the CNY so that the bilateral currency does not become expensive? The last time the rupee became expensive against the CNY, between 2015 and 2017, the bilateral trade deficit jumped. The worry is that if China is going to ease and the US is going to hike, that creates very peculiar tensions for most emerging markets.
On whether this mitigates the rupee slide problem to an extent
This year the rupee, in trade-weighted terms, has come down about 9%. I think most people will argue that for one calendar year, that is sufficient adjustment. It also has inflationary consequences. You have got some financial stability concerns — corporates with unhedged dollar debt, you don’t want too much of it. On a trade-weighted basis, it is 9% down. So the question is, even if we don’t depreciate on a trade-weighted basis, at least we should keep movement with our partner currencies, so that we may be depreciating with them against the dollar, but on a trade-weighted basis we are the same. The objective will be, at least on a trade-weighted basis don’t appreciate from these levels, remain more or less stable.