With U.S. economic growth inching upward, the Federal Reserve’s announcement in May that it might taper off quantitative easing – initiated to boost domestic growth – is sending emerging economies into a tailspin. Global economies are so inter-connected with the U.S. through trade and investment channels that the currencies of Brazil, Indonesia, South Africa and Mexico all fell. But the Indian currency was especially sensitive, falling to its lowest in 20 years.
Unlike long-term oriented foreign direct investments (FDIs), where overseas companies have factories that produce goods for Indian and other emerging markets, foreign institutional investors (FIIs) withdrew their funds from the Indian stock market back to the U.S., now on its way to economic recovery.
But that’s not the only reason. India has significant structural problems – high inflation, stalled infrastructure projects, regulatory barriers for overseas investors, and a large current account deficit – the country is a net debtor to foreign sources in trade and other channels.
“With respect to the ongoing financial market turbulence, investors appear to be discriminating across economies, focusing on those that are running external deficits,” says Paul Gruenwald, chief economist, Asia Pacific at Standard & Poor’s, Singapore. “In emerging Asia, the economies with the largest external imbalances are India and Indonesia.”
The slowdown in demand from the U.S. and Europe these past few years led India to focus less on exports and more on growing the domestic market. Raghuram G. Rajan, head of India’s central bank, wrote in an April 30 opinion piece in Live Mint:
“But domestic demand did not call for the same goods, and the goods that were locally demanded were already in short supply before the crisis. The net result was overheating – asset price booms and inflation across the emerging world.”
India’s wealthy consumers began buying gold as a hedge against inflation, currently at 10 percent. Policymakers, fearing a further increase in the current account deficit, responded by restricting gold imports.
The falling rupee also added to energy costs, as oil is the country’s largest import item. Unlike China, which enjoys a vast trade surplus and has artificially kept its currency devalued against the U.S. dollar to boost exports, India’s exports fall well short of its imports. But that could change.
“As the growth rate in the advanced economies picks up, India’s exports to these countries will also rise,” said Dr. C. Rangarajan, chairman of the Indian prime minister’s Economic Advisory Council. “The extraordinary increase in the import of gold in the last two years has been due to the high level of inflation in the country. But inflation, at least at the wholesale level, is coming down. This will help to curb the import of gold. Growth in the current fiscal will be higher than the last year.”
Already, the recently released data for August shows a decrease in the trade deficit. Also, drawn by attractive stock valuations, foreign investors are slowly re-entering the market.
The Connecticut Connection
The downturn in the U.S. led Connecticut companies to expand their footprint in India and other emerging markets to grow revenue. Despite a sharp slowdown in the BRIC economies – Brazil, Russia, India and China – overseas companies have succeeded in making money in those markets by offering niche products. Danbury-based industrial gasses company Praxair Inc. saw a nine percent increase in sales in Asia during the second quarter, compared to the corresponding quarter last year. The growth was driven by demand from customers primarily in China, Korea and India.
Stamford-based General Electric Company is also continuing to expand its market share in India by increasing its product offering in the healthcare and energy sectors. And Norwalk-headquartered Xerox Corp. recently launched a suite of new eco-friendly printers for small and medium sized Indian businesses.
Now, with the rupee weakening, profits earned from the sale of goods and services will convert to fewer U.S. dollars. Other economies have also experienced currency devaluations through the year, impacting corporate revenues. Praxair narrowed its year-end earnings guidance to $5.90 to $6, taking $0.05 off the top end.
“This reduction is purely a result of recent currency movements which we assume will prevail for the rest of the year,” said James S. Sawyer, chief financial officer, during the second quarter earnings call.
But companies with back offices in emerging markets are seeing huge cost savings. Financial software firm SS&C Technologies Inc. in Windsor has a large back office in Mumbai and pays rupee-denominated salaries to its employees.
“So our costs are reduced,” said Bill Stone, CEO. But he was quick to add that the benefit is temporary. “The flip side of saving about $750,000 per quarter is inflation and the devaluing of our cash balances,” Stone said. “We prefer stable currencies which support investment and growth.”
Mirza Baig, head of Foreign Exchange and Interest Rate Strategy, Asia, at BNP Paribas in Singapore, says the currency devaluation would spark an export led recovery in India. “Sure, it would inflict pain on foreign portfolio investors," Baig says. "But hey, they were aware of the risks going in."
Long-term oriented overseas investors are continuing to expand in emerging markets as nearly 60 percent of the world’s population lives there and are in need of a range of goods and services. The Eurozone is just emerging from a recession and the U.S. economy rose only 2.5 percent in the second quarter – both not enough to drive the balance sheets of multinational corporations.
According to consulting firm KPMG, cash-rich U.S.-based companies made 116 acquisitions in emerging and high-growth markets in the first half of this year. Meanwhile, companies in emerging and high-growth markets acquired 31 U.S. companies.
For high-technology Connecticut firms, long-term returns still appear to outweigh the risks in the region, although a shift in strategy may well occur in the second half of the year.
Q&A with Dr. C. Rangarajan
Dr. C. Rangarajan, chairman of the Economic Advisory Council to the Indian Prime Minister, and former governor of the Reserve Bank of India, the country’s central bank, discusses the currency crisis and the Indian government’s policy response.
Concern seems to have turned into panic over the continuous decline in the Indian rupee. Is the situation comparable with the 1991 financial crisis? [India was in a position where it could have defaulted on its foreign loans].
There is no parallel to the 1991 financial crisis. In the current situation, India is better placed to deal with the situation. In 1991, the foreign exchange reserves of the central bank were hardly enough to cover three weeks’ imports. Today, India has foreign exchange reserves, which can cover more than six months’ imports. The situation that India faces today is not unique to the country. Problems have arisen because of certain external decisions. The announcement of the Fed that it might anticipate tapering of quantitative easing resulted in the markets withdrawing funds from emerging market economies. If the Indian Rupee has fallen, so too have the Brazilian Real, South Africa Rand, Indonesian Rupiah, Turkish Lira, and Mexican Peso. Exchange rates have a notorious history of overshooting in such circumstances.
What factors are causing the rupee to fall to a record low?
India’s current account deficit has risen sharply in the last few years. Last year India’s current account deficit was 4.8 per cent of GDP. In absolute terms this amounted to U.S. $88 billion. This posed no problem because capital flows were adequate to cover the current account deficit. The currency also remained stable. In fact, the central bank added $3.8 billion to the reserves last year. The current pressure on the rupee is primarily traceable to the decline in the portfolio flows arising out of market reactions to the expected Fed decision to tighten liquidity at some future point.
Does the size of the current account deficit limit India’s policy tools to defend the rupee?
India has fairly large reserves. Capital inflows come through four channels as far as India is concerned. These are foreign direct investment, portfolio flows by foreign institutional investors, external commercial borrowings, and deposits in institutions/banks by non-resident Indians. Except for portfolio flows, flows through other three channels have not shown any decline. The actions taken by the Reserve Bank of India recently have been aimed at preventing speculative trading in the foreign exchange market. Flow of funds to speculators has been tightened. The government has clarified that India has no intention to impose any fresh capital controls.
How do you see the balance of payments evolving?
All efforts are being made to bring down the current account deficit to a more comfortable level. Our immediate aim is to take the current account deficit as a proportion of GDP to 2.5 percent.