Wednesday, 24 July 2013

Manmohan Singh's 1991 Rupee brahma astra may boomerang to a junk rating- An interesting reading

Rating companies and politicians have something in common - both are discredited, but indispensable in a socioeconomic system. The nation is suddenly back at a stage where one unreliable entity will evaluate the performance and potential of the other. The devil of a sovereign rating downgrade, that was nearly slain with the return of P Chidambaram to the finance ministry, who surprised by spending less than forecast - a sweet black swan event - is rearing its head again.

It is not the profligacy of the government this time, but a currency that is sliding fast and furious — partly due to global factors such as the US Federal Reserve tapering bond purchases, and mostly because of India's continued reliance on short-term flows to fund excessive imports.

A depreciating currency could be welcomed as a boon for a country suffering from a record high current account deficit — the excess of spending overseas than imports — as we did in 1991. Not quite in 2013.
Manmohan Singh as a finance minister in the PV Narasimha Rao Cabinet depreciated the rupee by a quarter and set the stage for an economic recovery after a balance of payments crisis in 1991. But as the head of the state, he could hardly afford that now. Government policies and finances are caught in such a web that his brahma astra of 1991 may probably boomerang this time with a sovereign downgrade to junk.

"The threat of a downgrade has more to do with India's current account deficit than with the exchange rate weakness per se,'' says Jahangir Aziz, senior Asia economist at JPMorgan Chase. "The rupee weakness, however, matters because it has the potential to widen this year's subsidy bill significantly, and therefore the fiscal deficit. To the extent that the rating agency is worried about India's CAD and fiscal deficit, the present situation clearly has not strengthened India's case for an improved outlook or rating.''

Indian Rupee has depreciated 10% since April amid fears that the Federal Reserve may taper its $85-billion of monthly bond purchases, shutting the liquidity tap for emerging markets. With announced reform measures not leading to a quick economic recovery, foreigners who flocked to India to benefit from higher returns have developed cold feet. After investing almost $30 billion between September 2012 and April 2013, they pulled out $5.3 billon since then. Standard & Poor's, which faces probe for its role in the 2008 credit crisis, rates India at Triple B- with a negative outlook and has warned that there are one in three chances of a downgrade in the next 12 months.

Moody's, which rated India Baa3 last week, said, "The fall in the exchange rate, by increasing the domestic prices of imported goods, will contribute to inflation, as well as to an increase in the government's expenditures, including on subsidies.'' Both ratings are investment grade, and a downgrade of one notch can make India a junk nation.

Government and the Reserve Bank of India have made consumption of gold, accounting for more than half the CAD, more difficult with restriction on imports and quadrupling import duty. The demand is falling, but relief from it is some way off. The bigger worry is crude oil, of which India imports more than three-fourths of requirements.

It has faced a double whammy with its price rising to $108 a barrel, from less than $98 and due to currency depreciation. Both translate into crude turning 20% more expensive than it was a few months ago. Fuel subsidy, which was Rs85,000 crore last year, and budgeted to be Rs90,000 crore, could bloat if oil remains where it is. Nomura Securities forecasts oil subsidy to rise by Rs8,100 crore for every Rs1 fall in the exchange rate. Petrol prices are market determined, but diesel is subsidised. So are cooking gas and kerosene, which account for half the subsidy. Raising prices of these fuels will pinch people. So that can be ruled out when the ruling class is headed to seek votes from the electorate.

"The government will also have to pay more on an increased fertiliser subsidy bill,'' says Sonal Varma of Nomura Securities. "Hence, a fiscal slippage is likely. The window for reforms is fast closing," she adds.

Government's foreign direct investmentboosting measures are not yielding immediate results. The big-bang opening up of multi-brand retail is yet to translate into investments. The government intends to raise foreigners' limit in telecom, defence and many other sectors.

"I don't think it's just a matter of opening up an FDI channel here or there, you have to address the root causes and send a signal that you are committed to making changes to narrow the deficits,'' says Subir Gokarn, former deputy governor of the RBI. "That is when you will start seeing new money from outside." CAD though may fall from the 4.8% of the GDP in 2013, but it may still remain far higher than the desired 2.5% for the next two years.

Fiscal deficit target of 4.8% of the GDP may be breached as government may not be able to squeeze expenditure as it did last year. Fiscal deficit worries will acquire bigger proportion given the economic slowdown where economists are lowering their target to just about 5% from more than 5.6%. Tax collections are falling behind budgeted estimates.

Indirect taxes rose 4.7% in the June quarter, compared with the fiscal year target of 20%. Direct taxes grew 12% in the fiscal first quarter, way below the 18% budget for the year. Sale of stake in state-run enterprises for Rs 40,000 crore appears tough, though staterun financial companies may be directed to bail out such sales. The revenue short fall and the weakening currency have created a rating risk, but it may not be there yet. "Although there is always a risk, I don't expect a downgrade,'' says Bimal Jalan, who conducted monetary policy during the previous downgrade and the 1997 Asian crisis as RBI governor.

"Growth may have declined, but our total borrowings are not very high and we have always been careful about borrowings abroad.'' The government may have bungled in its policy on subsidies and not getting its announcements translate into actual investments. But some are saying that the central bank may have also foundered in its currency operations. RBI should have shored up reserves when the flows were plenty, which it did not unlike during the times of Jalan, who also floated the Resurgent India Bonds and India Millennium Deposits, which some call a guerrilla attack.

Governor Bimal Jalan and deputy governor Reddy would buy as much FX as possible during periods of capital inflows and sell as little as they could during episodes of capital outflows,'' says Indranil Sengupta at Bank of America Merrill Lynch. "As these guerrilla-type tactics built up FX reserves, improved investor confidence led to capital inflows and, by extension, appreciation. Of course, times are different. CAD at 4.8% of GDP is four times of what it was in 1997. Fiscal deficit is budgeted at 4.8%, compared to last year's 5.06%. But some amount of consistency and strong measures should be taken, and there is a need to stand by them, even if painful. Last week's liquidity tightening by RBI and raising of short-term interest rates were a case in point. But those measures were diluted, and their impact were lot lesser than what they would otherwise have been.

If the twin deficits are not addressed in the next few months, the nation moves closer to a downgrade, even if it is by companies whose credibility has waned quite a bit. Investors are pouring in more money into Britain and the US after their downgrades. "Things can become much more ugly,'' says Aziz. "Right now, much of the CAD is being financed by short-term borrowing. A credit downgrade could spike the risk premium on such instruments, increasing next year's CAD and gross financing needs. This will, in turn, raise serious concerns about the sustainability of India's balance of payments.''

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