Quite a bit of economics is unfortunately about zero-sum games. Portfolio investors in India clearly have reason to cheer but on the flip side exporters have reason to fret. A restrained current account and a flood of capital flows have trapped the rupee in a narrow range. Forecasters including ourselves are slowly reconciling to the prospect of medium-term rupee appreciation.
A number of things have happened to break the pattern of orderly depreciation of the Indian currency over the last couple of years. First, the dollar seems to be slipping into a phase of secular decline and that should mean gains for the rupee. The immediate trigger is the political uncertainty stemming from the Russia affair. However, there are perhaps bigger concerns about US economic policy. The inability to repeal Obamacare has revealed both a deep divide within the Republicans and the equally disturbing fact that while they are past masters at blocking legislation, they do not have concrete alternatives in place. Besides, the impasse over the health Bill has meant that other critical issues such as tax reform have been put on the back-burner. America is facing its own version of policy paralysis and this is hardly good news for the dollar. The widely cited dollar index, a weighted basket of exchange rates has seen a nine per cent drop from its peak.
From an economist’s perspective though, there are other things that might cause more anxiety. After some traction in the first half, America’s economic data is sagging again. Despite historically low unemployment rates (that should, in theory, push up wages and inflation) inflation remains below the US central bank or the Fed’s target. Fed chair Janet Yellen’s recent statement at a congressional testimony that the current policy interest of 1-1.25 per cent (the Fed funds rate) was close to the neutral rate — a sort of steady rate at which inflation is stable — came on the back of the weak data.
This could be interpreted in different ways. One clear implication is that Yellen and her team are unlikely to hike the rate from its current range of 1-1.25 per cent. Thus, the “pull” of rising American interest rates that could draw capital into the US is likely to be much more muted than earlier. In fact, with Europe picking up and emerging markets back in fashion, capital could flow out of the US. This could also corroborate the claim that America’s trend growth rate is likely to be close to 2-2.5 per cent (the new normal if you like) rather than the aggressive three per cent that seemed to underpin Trump’s budget plans. Thus, aggressive tax cuts or large expenditures run the risk of bloating the budget deficit and ramp up debt. These proposals are likely to be either rejected or heavily watered down by legislators.
Shifting sentiment towards emerging markets has helped the stellar performance in India’s asset markets and the run-up in the rupee. India is thus not an isolated case. In fact, if one looks a little far back, the Indian stock market has performed exactly in line with the MSCI emerging market (EM) index. Emerging market currencies are up this year and currencies such as the Malaysian ringgit and the South African rand have seen year-to-date gains similar to the rupee.
Part of the EM turnaround comes on the back of renewed confidence in China and there is growing consensus on the fact that an imminent economic crash is not likely. Thus, the Asian heavyweight is not just seeing a cyclical pop but a durable trend — a new normal again — of around seven per cent growth that will survive things like monetary tightening. Over 77 per cent of growth in the first quarter came from consumption spending, an indication perhaps that China’s consumption-driven growth model is well entrenched. Finally, there is the new range for oil prices of between $45 and $50 a barrel that would support growth for net importers like India.
This is not to say that there won’t be corrections in the future. Markets or currencies rarely move along a one-way street. The question is: How deep will they be? In this world of new “normals”, going past gauges of overvaluation might just be a lost cause.
Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is chief economist, CII