The US Fed, on September 17, 2015 may finally decide to increase the US interest rate after nine long years. Or it may decide to remain eloquently indecisive and prolong the wait and anxiety of global investors. However, as far as India is concerned, it is possibly more optimally placed to handle a US Fed-induced spillover effect than it was any time since FY11. However, as with all good things, this current Indian strength may not exist eternally. Rather there is a possibility that the strength of the Indian economy as well as its currency may wax and wane over a period of the next six to 12 months.
As is oft reported, India’s economic fundamentals have improved significantly since the days of ‘Taper Tantrum’. The tantrum was felt in the global market in May 2013 when the US Fed first hinted that the cornucopia of cheap global liquidity (also known as Unconventional Monetary Policy) may be turned off. The recent China scare provided a good opportunity to evaluate how well-positioned India may be to handle an US rate hike.
Handled ‘China scare’ well
The rupee was among the strongest performing currencies, within the emerging market (EM) space, in the 18-month period running up to the ‘China scare’ in July 2015. It depreciated against the dollar by just 2.8% during the period. As China resorted to ‘QE’ and variety of measures to prop up their stock market as well as their economy, global financial markets experienced a selloff and rushed towards safe havens in the second and third week of August. However, it provided India a much needed dress rehearsal before the main show. And India did reasonably well during the period.
As with any crisis, the preference for bespoke safe havens resurfaced. So during the ‘crisis’ period euro, pound and the Singapore dollar performed quite well despite having depreciated against the USD by 22%, 5.8% and 5.7% in the 18 months prior to July 2015, a much worse performance than that of the rupee. During the period of the crisis, rupee depreciated by 3.8% against the dollar; a performance comparable to Mexico (4.1%) but worse than Philippines (1.5%), Thailand (1.5%), South Africa (1.6%), South Korea (1.8%) and Indonesia (2.5%) and for that matter even Brazil (1.2%). With the exception of Philippines, each of these currencies has performed worse than the rupee in the preceding 18 months. Of course, the rupee's performance was not an outlier, that trophy goes to Kazakhstan (25.1%) and Russia (7.7%).
Post the peak of the scare, in the last week of August 2015, the currencies ‘normalised’. Euro and pound depreciated by 2.6% and 2.8%. Brazil (5.9%) and South Africa (2.3%) continued with their depreciation against the dollar. However among several countries whose currencies bounced back, the rupee figured prominently along with Philippines, Mexico, South Korea and Russia. With respect to currency strength post the scare, the appreciation of the rupee (0.7%) was somewhere in the middle of the pack after Russia, South Korea but ahead of Philippines. On the whole, a good fight by the rupee if not a podium finish! But more was expected given that the rupee was among the strongest performing currencies in the run-up to the scare and its economic fundamentals improved a lot more than most of its EM peers.
Hardly breaking a sweat
What should give further solace to the above performance is the fact that during the peak of the crisis, the RBI had to spend just $2.59 billion from its reserves to support the rupee, leaving a reserve of $351.9 billion as of August 28, 2015. During the period April 26, 2013 to September 6, 2013, RBI had to scoop out $21.57 billion out of its reserves and still failed to stem the rupee from depreciating by over 20%.
Ready as it can be
Hence, the rupee can be one of the currencies that will bounce back after the crisis blows over. What else is in our favour? Of the $350 billion plus reserves with RBI, even if a humongous $40 billion is scooped out to combat a severe crisis it should not worry us too much. Why? Because given the low crude price, even if reserves are depleted to $310 billion it would still support around 10 months of import. With a real interest rate estimated at 7%, the rupee will remain one of the more attractive currencies fundamentally, so global investors will flock back to the rupee after the crisis.
Primed for Fed action
For all one knows, even if the US Fed increases the rate, given that the financial markets are anticipating it, the impact of the same may be more of a damp squib in comparison to what doomsday seers have been predicting. Alternately, if there is a spillover effect, the crisis period may be more like weeks than months. Post that, the world will go back to business as usual, maybe under some ‘New new normal’. India given its fundamentals would most likely remain top of mind for global investors. The RBI would possibly be more amenable to a rate reduction to the extent of 50 basis points to 75 basis points. Even the government may be more willing to take a risk by loosening its purse strings further. Clearly, the upside would be more than the downside.
What if Yellen blinks?
If the Fed does not hike on September 17, but gives forward guidance and pushes the event to December 2015 or beyond, then it may not be the best thing for India. The continued uncertainty may restrict RBI’s leeway to reduce only 25 basis points so that the real interest rate cushion continues to remain high in anticipation of future spillover events. Likewise, the government may continue to be risk averse and single-mindedly try to control government spending so as to be in line with its fiscal deficit target. The end result may be that the Indian economy may underachieve on the growth front; investors may become impatient and sell equities, which in turn may pressure the rupee. In short, the current strength may erode…but that is getting ahead of ourselves, let’s wait for September 17.