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.

• 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