The latest interest rate hike by the US Federal Reserve and by the Swiss Central Bank (ending the era of negative interest rates in Europe) demonstrates the new-found resolve of central banks in developed economies to bring inflation under control. The US Fed was late in picking up on the signs of rising inflation, and its non-temporary nature. But adherence to faster and sharper rate hikes might absolve it of the acts of omission for the time being. The Fed dot plot now shows that rates may continue to rise in 2022 and even in 2023, touching 5 per cent. This is a worrying number for global markets.
The fact that major central banks — the European Central Bank, the Bank of England and the Bank of Japan — have lagged the US expectations on the pace of rate hikes has exacerbated the situation, spurring the Dollar index to its 20 years highs, and beyond. This is one of the few times when currencies of developed economies are witnessing more weakness than those of emerging market economies. The Euro, having broken parity, is trading at a two decade low and could well inch towards its all-time low of 0.8231 seen in October 2000. Another major currency, the Yen, is below its low of 1998, prompting the Bank of Japan to intervene in the markets on Thursday for the first time since June 1998 to protect the crucial level of 145. The Pound could see further weakness as a chequered political landscape and adverse climatic conditions push it to its 1985 lows of 1.05 against the dollar. For currencies of emerging market economies, the fall during the turmoil has been less wild, a reversal of the trend observed during the taper tantrum. This “relative” performance by emerging economies like India is often ignored by puritans while assigning an abstract value to the depreciation of currency.
Against this volatile background, the fall of the rupee past 80 against the US dollar was inevitable. Till now the RBI had been protecting the currency from crossing this psychological benchmark and keeping the volatility under control. However, after the recent hike by the US Fed, and the dot plot indicating the possibility of a terminal rate of around 5 per cent, the rupee has depreciated, crossing the 80 mark. No central bank can prevent a currency depreciation at this juncture. In this environment, the RBI might allow the rupee to depreciate, though only for this period. The currency looks still overvalued when weighed against the real effective exchange rate and the nominal effective exchange rate.
Moreover, the RBI has already used foreign exchange reserves of around $75 billion since the Ukraine war, to support the rupee. This has reduced the import cover to nine months. There is always a trade-off in using the foreign exchange reserves to defend the currency. This stance may have been justified as much of the weakness in the rupee has been due to a strong dollar and not India’s domestic economic fundamentals. The rupee has depreciated by a modest 6.7 per cent vis-à-vis the US dollar since the war broke out while the Dollar index has appreciated by 15 per cent during the same period. This means that the rupee will bounce back strongly once the dust settles — research shows that after a fall, the rupee inevitably stages a strong comeback. This is a fair assumption under the current circumstances, as India’s macroeconomic fundamentals are strong enough to warrant a bounce back.
However, the best thing that might have happened to India post the Ukraine war — a harbinger of a new India in the making — has been the robust performance of equities. The resumption of foreign portfolio flows pitches the “uniquely Indian” theme. Thus markets haven’t fallen as much when compared to the fall in developed economies. Nor did any panic set in when FPIs were retiring portions of their funds earlier in the year. Though it may be noted that portfolio inflows have revived strongly in August and continued in September with an inflow of $10 billion – 68 per cent of the outflows during April-July. This “decoupling” is a harbinger of things to come.
The other decoupling that has occurred is that domestic yields at the longer end of the tenure have been contained, even as global yields have shot through the roof. These developments are new to conventional macroeconomics wisdom.
The decoupling story is however not an outlier. With increased private participation in new investment announcements (around 70 per cent), economic prospects appear to be on track, backed by strong corporate and household balance sheets. The MSME sector, a proxy for the informal economy, has proved naysayers wrong. Recent data captures the resilience of the sector, first in the face of the pandemic and now with slippages nowhere near the levels envisaged some time back. In fact, even the net NPA levels of MSMEs (those against which no provision has been made) are quite within the comfort zone of banks. Collections have improved, and accounts are getting upgraded in possible cases.
We end with an interesting anecdote. There has been a record jump in housing loan disbursements in 2021-22. And that has continued in 2022-23. The demand is coming from tier 3 and tier 4 cities, with a larger preponderance of women among the borrowers. This rising demand for home loans in such cities can be attributed in part to the SVAMITVA scheme that acts as a force multiplier for those residing in rural areas with the right to document their residential properties previously non-existent. This shift in demand towards smaller cities augurs well for creation of better social infrastructure in education/healthcare facilities in future. Growing participation by Digital Sakhis under the aegis of National Rural Livelihoods Mission/State Rural Livelihoods Mission, which has ushered in a marked behavioural shift through rapid financialisation of women, is another enabler. Clearly, there is decoupling here also — a welcome shift from the hitherto male-dominated loan book of financial institutions.
The author is Group Chief Economic Advisor, State Bank of India. Views are personal