Weak Indian rupee to fuel capital
flight By Jephraim P Gundzik
Concerns are growing that accelerated
depreciation of the Indian rupee will trigger
widespread foreign capital flight and further
exchange rate weakness.
Rising inflation
and growing perception that the Reserve Bank of
India, the country's central bank, has fallen
behind the inflation curve began to exert downward
pressure on the rupee in mid-2005. Widening trade
and current account deficits are likely to
intensify this pressure in 2006.
Since
July 2005 the rupee has depreciated by about 6% against
the US
dollar (about 46.2 to the dollar on Tuesday) and
about 3% against the euro. The downward drift of
the rupee was initiated by the bank's reluctance
to lift the official bank rate from its lowest
level (6%) in more than 30 years despite
increasing inflationary pressure. Unbridled growth
of private consumption coupled with rapidly rising
international oil prices are pushing inflation
higher.
Though statistics covering the
expenditure breakdown of gross domestic product in
the first two quarters of fiscal 2005-2006 are
unavailable, continued very strong growth of
personal loans indicates that private consumption
growth is accelerating. Personal loans expanded at
a nominal rate of more than 20% in fiscal
2003-2004, more than 50% in fiscal 2004-2005 and
at an annualized rate approaching 70% thus far in
fiscal 2005-2006.
Though the government
has passed on only about one-third of the increase
in international oil prices since 2004, domestic
fuel prices have increased. The continued increase
of international oil prices ($61 a barrel Tuesday)
will eventually force India's government to raise
domestic fuel prices as the cost of this implicit
fuel price subsidy is pushing the central
government deficit higher. By the end of fiscal
2005-2006 (in March) India's wholesale price
inflation is likely to be about 7% - up from 5% at
the end of fiscal 2004-2005.
While the
Reserve Bank of India falls further behind the
inflation curve, the trade and current account
deficits will surge higher. In fiscal 2004-2005,
India's trade deficit doubled to $28 billion,
thanks to sharp growth of consumer goods and oil
imports, producing a current account deficit of
US$7 billion. Continued very strong growth of
these imports in the first half of fiscal
2005-2006 (April-September) have placed the trade
and current account deficits on a trajectory to
reach about $50 billion and $25 billion,
respectively, by March.
India's growing
dependence on oil imports and the continued rise
of international oil prices ensure that import
growth will remain far above export growth in the
first half of fiscal 2006-2007. This will push the
trade and current account deficits higher. With
inflation and the trade and current account
deficits increasing rapidly, further depreciation
of the rupee is inevitable. Foreign capital flight
could intensify this depreciation.
Strong
economic growth has attracted substantial foreign
investment to India in the past three years.
However, the same factor that is undermining
domestic investment, namely the poor state of
infrastructure, has channeled most of this
investment into Indian equities and bonds. In the
past two years about $20 billion of foreign
portfolio investment has flooded into India. These
inflows have slowed in the first half of fiscal
2005-2006 to an annualized rate of about $3
billion.
India's banks joined foreign
investors with voracious borrowing abroad to
finance domestic bond investments. By the end of
fiscal 2004-2005 the domestic government bond
portfolios of India's banks were equivalent to 60%
of total loans outstanding. Since fiscal
2002-2003, foreign borrowing by India's banks has
amounted to more than $25 billion.
The
common factor linking foreign portfolio investment
with foreign financed domestic investment by
India's banks is the short-term nature of these
inflows. In other words, once investment
conditions and/or the exchange rate weakens, these
investments are likely to be unwound. Combined
with other foreign short-term capital inflows, the
total stock of potential flight capital in India
is probably about $55 billion. Adding to this, the
stock of non-resident deposits originally
attracted to India by exchange rate stability
further increases the stock of potential flight
capital.
Though India's foreign exchange
reserves are about $130 billion, they are
insufficient to withstand both a surge in the
current account deficit and foreign capital
flight. Capital flight sufficient to provoke a
balance of payments crisis may be improbable.
However, with a large current account deficit
there is plenty of scope for capital flight to
drain a very big portion of India's foreign
exchange reserves.
Developments in India's
balance of payments in the past two years are
strikingly similar to developments in Russia's
balance of payments in the late 1990's. Foreign
capital flight from Russia eventuated the
devaluation of the ruble in 1998. India could well
find itself on the same path in 2006.
Jephraim P Gundzik, president,
Condor Advisers, Inc, email:
jpg@condoradvisers.com
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