<p>India may face its worst financial crisis in decades if it fails to stem a slide in the rupee, leaving the central bank with a difficult choice over how to make the best use of its limited reserves to maintain the confidence of foreign investors.<br /><br />Unlike most of its Asian peers, India routinely runs large current account and fiscal deficits. That means it must attract sufficient foreign money, namely dollars, to close the gap, and a weaker home currency makes that costlier. What makes the current situation so worrisome is that India is grappling with big internal and external economic threats simultaneously: Growth is slowing. Inflation remains high. Political paralysis has stymied domestic overhauls.<br /><br />The Reserve Bank of India (RBI), the last line of defense against a currency meltdown, has cautiously begun to support the rupee, but its firepower may be more limited than its $300 billion in reserves would suggest. Beyond India’s borders, Europe is the biggest worry. As its banks deleverage, investment money has flooded out of Indian markets. If European debt troubles worsen, India could be hit with a balance of payments crisis as severe as the one that forced a sharp devaluation in 1991.<br /><br />The rupee, which has dropped 16 per cent in the past four months, got a reprieve last week after six of the world’s big central banks banded together to try to ease dollar funding strains, helping it break a four-week losing trend. But analysts widely expect the rupee to resume its slide.<br /><br /> “The Indian currency will be the first casualty of a deterioration in the euro zone crisis,” said Mumbai-based the Bank of Baroda chief economist Rupa Rege Nitsure. If the European crisis deepens, the Indian trade deficit would widen even more rapidly, and India would have even more trouble attracting foreign capital.<br /><br />“Risk appetite will obviously collapse, and gradually the currency crisis is likely to take the shape of a balance of payments crisis,” Nitsure said. India’s current account deficit swelled to $14.1 billion in its fiscal first quarter, nearly triple the tally of the previous quarter. The full-year gap is expected to be around $54 billion.<br /><br />Its fiscal deficit hit $58.7 billion in the April-to-October period. In February, the government projected a deficit equal to 4.6 per cent of gross domestic product for the fiscal year ending in March 2012, although the finance minister said Friday that it would be difficult to hit that target. India relies heavily on portfolio inflows, which are foreign purchases of shares and bonds, as a means of covering its current account gap. Those flows are fickle.<br /><br />Foreign portfolio investors have sold a net $50 million worth of equities so far in 2011, in sharp contrast to the $29 billion they invested in 2010, data from the Securities and Exchange Board of India’s (Sebi) website shows. In November alone, foreign funds pulled $661 million out of Indian stocks.<br /><br />“The Indian economy is one of the most vulnerable to liquidity shocks in the region, not helped the least by deficits in its key balances,” said Singapore-based Forecast PTE economist Radhika Rao. The drop in portfolio inflows and the hefty current account and fiscal deficits have been the main factors behind the rupee’s decline.<br /><br />The RBI appears to have intervened to try to slow the decline. Between October 28 and November 25, reserves dropped by $16 billion to $304 billion, yet the rupee still fell by 7 per cent during that period. Trading in rupee offshore forward contracts shows traders are betting on the rupee’s declining a further 1.7 per cent over the next three months and 4.5 per cent over a year. Many economists argue that the RBI has been too timid and deserves part of the blame for the rupee’s weakness.<br /><br />“The biggest mistake RBI has made is that it has almost given an open invitation to speculators to short the rupee,” said Singapore-based CLSA economist Rajeev Malik. “It is really bizarre for any central bank to openly keep on saying that it will not intervene when there is already pressure on the currency to weaken and globally things are so uncertain.”<br /><br />Normally, higher interest rates bolster currencies, so the rupee’s weakness is all the more significant. If the RBI decides to step in more aggressively, its maneuvering room is more limited than its reserves tally would suggest. After covering the current account deficit, short-term debt and foreign investment flows, there would be less than $20 billion left over.<br /><br />Mumbai-based IndusInd Bank head (Market and Economic Research) J Moses Harding said that the Reserve Bank’s immediate concern would be stopping the spread of currency woes into the money market. The Indian banking system already borrows more than $19 billion from the central bank to meet reserve requirements, so if the RBI moved to prop up the rupee, it would drain more liquidity out of an already tight market.<br /></p>
<p>India may face its worst financial crisis in decades if it fails to stem a slide in the rupee, leaving the central bank with a difficult choice over how to make the best use of its limited reserves to maintain the confidence of foreign investors.<br /><br />Unlike most of its Asian peers, India routinely runs large current account and fiscal deficits. That means it must attract sufficient foreign money, namely dollars, to close the gap, and a weaker home currency makes that costlier. What makes the current situation so worrisome is that India is grappling with big internal and external economic threats simultaneously: Growth is slowing. Inflation remains high. Political paralysis has stymied domestic overhauls.<br /><br />The Reserve Bank of India (RBI), the last line of defense against a currency meltdown, has cautiously begun to support the rupee, but its firepower may be more limited than its $300 billion in reserves would suggest. Beyond India’s borders, Europe is the biggest worry. As its banks deleverage, investment money has flooded out of Indian markets. If European debt troubles worsen, India could be hit with a balance of payments crisis as severe as the one that forced a sharp devaluation in 1991.<br /><br />The rupee, which has dropped 16 per cent in the past four months, got a reprieve last week after six of the world’s big central banks banded together to try to ease dollar funding strains, helping it break a four-week losing trend. But analysts widely expect the rupee to resume its slide.<br /><br /> “The Indian currency will be the first casualty of a deterioration in the euro zone crisis,” said Mumbai-based the Bank of Baroda chief economist Rupa Rege Nitsure. If the European crisis deepens, the Indian trade deficit would widen even more rapidly, and India would have even more trouble attracting foreign capital.<br /><br />“Risk appetite will obviously collapse, and gradually the currency crisis is likely to take the shape of a balance of payments crisis,” Nitsure said. India’s current account deficit swelled to $14.1 billion in its fiscal first quarter, nearly triple the tally of the previous quarter. The full-year gap is expected to be around $54 billion.<br /><br />Its fiscal deficit hit $58.7 billion in the April-to-October period. In February, the government projected a deficit equal to 4.6 per cent of gross domestic product for the fiscal year ending in March 2012, although the finance minister said Friday that it would be difficult to hit that target. India relies heavily on portfolio inflows, which are foreign purchases of shares and bonds, as a means of covering its current account gap. Those flows are fickle.<br /><br />Foreign portfolio investors have sold a net $50 million worth of equities so far in 2011, in sharp contrast to the $29 billion they invested in 2010, data from the Securities and Exchange Board of India’s (Sebi) website shows. In November alone, foreign funds pulled $661 million out of Indian stocks.<br /><br />“The Indian economy is one of the most vulnerable to liquidity shocks in the region, not helped the least by deficits in its key balances,” said Singapore-based Forecast PTE economist Radhika Rao. The drop in portfolio inflows and the hefty current account and fiscal deficits have been the main factors behind the rupee’s decline.<br /><br />The RBI appears to have intervened to try to slow the decline. Between October 28 and November 25, reserves dropped by $16 billion to $304 billion, yet the rupee still fell by 7 per cent during that period. Trading in rupee offshore forward contracts shows traders are betting on the rupee’s declining a further 1.7 per cent over the next three months and 4.5 per cent over a year. Many economists argue that the RBI has been too timid and deserves part of the blame for the rupee’s weakness.<br /><br />“The biggest mistake RBI has made is that it has almost given an open invitation to speculators to short the rupee,” said Singapore-based CLSA economist Rajeev Malik. “It is really bizarre for any central bank to openly keep on saying that it will not intervene when there is already pressure on the currency to weaken and globally things are so uncertain.”<br /><br />Normally, higher interest rates bolster currencies, so the rupee’s weakness is all the more significant. If the RBI decides to step in more aggressively, its maneuvering room is more limited than its reserves tally would suggest. After covering the current account deficit, short-term debt and foreign investment flows, there would be less than $20 billion left over.<br /><br />Mumbai-based IndusInd Bank head (Market and Economic Research) J Moses Harding said that the Reserve Bank’s immediate concern would be stopping the spread of currency woes into the money market. The Indian banking system already borrows more than $19 billion from the central bank to meet reserve requirements, so if the RBI moved to prop up the rupee, it would drain more liquidity out of an already tight market.<br /></p>