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.
- Clearly, depreciation raises the rupee costs of imports.
- 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