The U.S. Federal Reserve shocked the market on 18 September 2013. Ben Bernanke said the Fed would postpone tapering its USD 85 billion per month bond buying program possibly until next year. Sluggish growth forecasts, low inflation, persistent unemployment and fiscal fights are the main rationales behind the decision. The Fed is also likely to keep the short-term rates near zero until the unemployment rate falls below 6.5%. Investors in India hailed the zero taper: stock markets soared and local currency exchange rates dropped.
They certainly have good reasons to feel happy. India has run on an increasing current account deficit over the last five years, from 2.3% of GDP in 2008-09 to 4.6% (Figures 1 and 2). The deficit can be financed with either India’s foreign exchange reserves or foreign capital inflows, if sharp rupee depreciation is to be avoided. This was where quantitative easing (QE) came into play. Yield-seeking capital flooded developing countries since the start of QE: Indian equity and debt market have received USD 105 billion from foreign institutional investors. Yet since June 2013, hot money started leaving India after the Fed talked about tapering QE, driving exchange rates to a record high of 68.8 in August (Figure 3). The zero taper decision reversed the previous message, which gave India some breathing room to weather the economic plight.
Figure 1: India current account to GDP (mid-2008 to mid-2013)
Figure 2: India current account (2008 to present)
Figure 3：Indian rupee exchange rate (2008 to present)
A stable rupee is particular good news for Indian debtors. Indian companies have accumulated huge overseas borrowings due to low interest rates in global markets. India’s corporate sector holds $48 billion in outstanding U.S. dollar debt, half of which is in the banking sector. Among India’s total external debts, 57.2% was denominated in U.S. dollars as of March 2013, which valued over $200 billion. Over half of these debts were unhedged. This means a plunging Indian currency could derail companies with heavy foreign currency debt. This could be traumatic given India’s weakened economic growth.
Apparently, India gets more time on the clock, after the Fed’s announcement. However, the right question to ask is whether there is enough time for India to re-balance their current account and deleverage their economy.
The Indian government has begun reining in the current account deficit this year by cutting imports, particularly in oil and gold. They plan to contain the deficit to USD 77 billion this financial year, down from $88.2 billion last year. To strengthen the capital account, they have raised interest rates and are planning to liberalize external commercial borrowings guidelines. Moreover, positive developments in India’s current account occurred before the Fed’s announcement: the deficit fell to 3.6% of GDP in the first quarter of 2013, closer to the 2.5% safety zone.
However, both raising interest rates and cutting imports will have a toll on the economy. Increasing interest rates hurt the economy by making debts less affordable. Cutting imports can also be damaging, especially for India, which imports 75% of its oil. India’s problem is not just balancing its current account: keeping capital inflows stable and maturing debt serviceable are equally important. If the economy slows down, investors will have less to gain and thus exit the market, putting pressure on the capital account balances. A bad domestic economy certainly would not help companies repay their domestic and international debts.
Therefore, India is trapped either way. Procrastination on cutting current account deficits increase the economic costs when the U.S. starts tapering QE. On the other hand, adjustments today may hurt investors’ confidence and the economy. U.S. economic policies now hardly affect what India has to go through in the future. India has not been saved by the bell.
