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There are differences between now and 1997-98, but sufficient similarities too for us to draw lessons from the past, about the recent RBI’s policies to strengthen the rupee. RBI's goal could be to reduce volatility, and not set a level for the rupee; it would provide the time needed for the economy to adjust to the weaker rupee, according to Credit Suisse
There is much uncertainty on how long the Reserve Bank of India (RBI)'s recent tightening of liquidity will last, and what the impact is going to be. However, looking at the lessons learned during similar situation in 1997-98, we can say that the liquidity restrictions will last for the next two-three months, says Credit Suisse.
According to Credit Suisse, it may be tempting to extrapolate regulatory steps (taken by the RBI) during the 1997-98 crisis to the current scenario, but this would be unwise. However, it there are indeed certain lessons one can draw safely:
1) If the rupee stabilises for one-two months, the RBI is likely to reverse these moves. When it reversed its moves in March 1998, two months after raising rates, the trade deficit was still rising, and capital flows were still weak and negative. The Resurgent India Bonds were issued only after the Pokhran blasts (nuclear tests).
2) A sustainable move in the currency only happens with changes in trade and current account deficits and inflation. The RBI’s steps can at best help provide the necessary time for the economy to adjust around a new currency level. But the adjustment around that new level must necessarily happen either through an increase in exports or a fall in imports. We believe that in two-three months, the deficits will be sustainably lower than they are now.
3) The broader market is likely to look through some of these changes: as seen in below figure, the Nifty follows its own rhythm, rather independent of the currency.
According to Credit Suisse, there are some striking similarities between the developments of 1997-98 and the current events. During 1997-98, as now, the Indian economy was coming off an investment binge, and after a bout of high inflation, had started to see a reduction in rates. Other emerging markets (EMs), and in particular the South-East Asian markets, after a period of hyper-normal growth, had entered a crisis phase.
This had driven a reversal in flows, especially after the Pokhran nuclear bomb tests, where even External Commercial Borrowings (ECBs) by Indian corporates reversed and then dried up. The more volatile forms of capital flows like short-term debt and portfolio flows had reversed too, as one would expect.
The RBI got into the act after the first round of sharp depreciation, as the rupee fell 9% in November 1997. Its attempts during December 1997 were relatively mild: a 50 basis points (bps) increase in the cash reserve ratio (CRR), attempts to make non-resident Indian (NRI) deposits more attractive for banks, and tweaking fund flows for exporters and importers.
However, after keeping all measures unchanged in December 1997, as the rupee began to fall again, (falling almost 4% in the first 15 days of January), it dramatically raised rates: a 2 percentage point (pp) hike in the bank/repo rate, and a 50 bp increase of CRR.
However, as the US dollar and rupee stabilised at 39-40 levels, within two months, the RBI started to reverse this move and by April 1998, the bank rate was back to 9%. Interestingly, foreign institutional investment (FII) flows, as well as short-term debt, were negative for two quarters after that, likely affected by the sanctions imposed post the Pokhran test in May that year.
By June, however, the global economy and trade and capital flows had started to stabilise, and the trade deficit started to narrow again, as exports picked up from July 1998. Rates continued to fall and even the downward trend in CRR continued, except for a short blip when the Russian crisis started. In August 1998, the Resurgent India Bonds were issued as well, which brought in $5 billion, which was more than the current account deficit (CAD) for FY1999.
…And the differences
There are some meaningful differences between then and now which should drive some caution in applying these lessons from history, according to Credit Suisse.
Difference1: No crisis yet
At present, none of the EMs has a crisis yet, but one cannot rule one out for the next several quarters. Greater capital account convertibility of the rupee has in some ways has given a forewarning, though some would call it less information and more speculation. While we continue to believe that the US dollar and rupee should settle at lower levels, given the record low level of the 36-country REER for the rupee, in case there is a crisis, foreign debt outflows can drive another sharp leg down for the rupee, Credit Suisse said.
Difference2: The external linkages are much larger
The Current Account Deficit both in absolute and real terms is now much larger than it used to be 15-16 years back. In FY98/FY99 the ‘hole’ that needed to be plugged was much smaller than it is now. But that said India's ability to attract and absorb capital flows is also now much larger.
Since 1998, a number of sectors have been opened up for FDI, and FII and ECB limits have been relaxed significantly. Further, the Indian stock market is now about 7.8x as large as it was then, even in the US dollar market capitalization. It is noteworthy that FDI and NRI deposits were remarkably consistent even in the face of a global crisis, and the precipitous fall in the rupee did not affect them.
Both FDI and NRI deposits have over the past few years have been quite high, measuring about $20-$30 billion and we don’t see any reasons for them to slow meaningfully, Credit Suisse said.
Difference3: Liquidity problem is worse, much worse
While we reiterate that we do not see a solvency issue for India, the liquidity problem is much worse than it used to be, finds Credit Suisse. Given the over-reliance on short-term funding, particularly over the past year, debt due in FY14 is close to two-thirds of India's currency reserves. This is what worries the RBI/ government.
Difference #4: No freeze on capital flows (no sanctions!), no dollar bonds (yet)
There hasn't been (at least so far) any freeze in trade-related flows, either due to financial system stresses or due to political reasons like post the nuclear tests in 1998, Credit Suisse points out.
Are global investors, enamoured of emerging and frontier markets, ignoring the many negatives?
1. The recent rise of Frontier Markets has been due to a commodities and consumer credit boom. As China slows and the Fed tightens, both are going away.
2. Frontier markets are relationship based (as opposed to rule based) systems. They have economically inefficient legal infrastructures that lead to asymmetries of information and distort allocations of capital. This is a recipe for boom and busts. Investors in Brazil had to wait more than 20 years after its bust for it to regain respectable growth.
3. It is very difficult for retail investors to find vehicles to invest in Frontier Markets. For example one of the best recently performing markets has been the UAE which has increased 28%. The safest way to invest would be the DFM General Market Vectors Gulf States Index ETF (MES). But it is small ($11 million) and represents other Gulf States. It was up only 16%. Other markets that did well this year include: Argentina 27%, Nigeria 19%, Kenya 15% and Botswana 16%. But none have their own ETF.
4. These markets (and the BRIC markets) are usually concentrated in a few companies that are often state owned. These companies are invariably financial or commodities. They often reflect global not local conditions.
5. The corporate governance is dreadful. The regulatory regimes are appalling. They are all exceptionally corrupt. If the economy is growing, that means that someone is making money, but it may not be investors.
6. The demographic advantage of hoards of young people is more of a disadvantage than advantage. Many of these countries’ sole export are commodities. When it is easier for the elite to extract profits from the ground rather than the economy, there is little incentive to create the institutions for sustained growth. This leads to a plethora of ill educated, unemployed, frustrated and angry young men who are a threat to social stability.
7. These markets are very volatile and subject to every sort of financial abuse from insider trading to outright fraud. If you are very lucky you might catch an updraft, but don’t count on it being sustained.
The first emerging markets boom occurred in 1824. After the Napoleonic wars interest on British government bonds (consuls) fell to 3%. As a result there was a search for yield. Investors bought into the bonds of newly created countries like Mexico, Brazil, Columbia and Guatemala. These bonds were yielding about 6%. By 1826 the market value of Columbia bonds had fallen 50%.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)