Vulnerability due to Depreciation

What is the issue?

The current rupee depreciation is likely to contribute to the vulnerability of the economy.
A look at the causes (policy shortfalls) and the consequences of it becomes essential.

What are the recent developments?

Foreign investors are exiting from India’s financial markets.
This is triggered by the end of quantitative easing in the US and Europe.
It is particularly by the hikes in policy interest rates in the US, making investments attractive.
This has resulted in a sharp depreciation of the rupee relative to the dollar.

What led to this?

Crisis - The US and Europe infused liquidity after the 2008 financial crisis.

Credit at near zero interest rates was available to banks and financial agents.
This was to lend or invest at low rates to record profits.
Thereby it facilitated resolving their balance sheet hit by the crisis.
It flooded markets with large volumes of cheap money in the process.
Carry trade - Under this, banks, financial institutions and investors borrowed cheap in the dollar market.
But they invested in assets denominated in other currencies for higher returns.
The rush of funds shored up these currencies and even resulted in appreciation.
India was a country that benefited from flows of this kind.
India’s corporate sector utilised the cheap credit from foreign financial firms.
Impact - This has resulted in a high proportion of outstanding foreign bank claims.
India is now paying the price for this legacy of debt.

It also increases the rupee equivalent of payments made to service foreign debt.

How has the bond market been?

The channels through which credit has been flowing into the country has changed.
Clearly, the share of bank loans and deposits has come down from 2013 to 2017.
While, the share of debt securities has increased in the same period.
The corporate bond market which was inactive for long had turned active in recent years.
Financial institutions in the carry trade, experimented with corporate bonds.
This suited Indian corporates as bond issues are likely to have less intensive scrutiny.
However, exit is much easier for bond investors.
They can choose to book profits or cut losses and leave.
But this results in stress on the balance of payments and the rupee.

What are the policy shortfalls?

The current vulnerability could have been prevented by policy decisions.
The corporates should have not been encouraged to exploit that supply-side push.
But, the ceilings on external commercial borrowing have been relaxed hugely over the liberalisation years.
Foreign investors have been given easy access to the country’s debt markets.

How do these make India vulnerable?

The debt exposure allowed by the above has now created two kinds of vulnerabilities.
Firstly, it can lead to rupee depreciation when investors choose to exit.
This intensifies any depreciation resulting from other factors.
Secondly, depreciation increases the rupee costs of servicing foreign debt.
It can lead to losses and push firms to default on both domestic and foreign debt.
Vulnerability that legacy debt creates arises from the volume of exposure.
But besides, it also arises from its likely concentration in a few firms.
How - Firm reputation influences access to foreign credit markets and institutions.
It is thus likely that foreign debt would be concentrated in a small number of firms.
This factor carries the enhanced debt-servicing burden for these few companies due to rupee depreciation.

Source: BusinessLine