The rupee seems likely to be inexorably headed lower over the next few months. Given the shape of the economy, the huge twin deficits and the chaotic political situation, it's likely that the rupee will end up quite a lot lower than its current level. What's likely to be the impact on the stock markets and the overall economy?
East Asia suffered a financial crisis in 1997 - the so-called Asian Flu. A description of what happened may help Indians get a better sense of possible scenarios. There were many similarities and also many differences.
One point in common was that the East Asians had high current account deficits and too much overseas debt. Quite a lot of overseas liabilities were of private businesses. In India, overseas corporate debt amounts to nearly 30 per cent of all overseas obligations.
Short-term overseas debt was also very high in East Asia. World Bank data says short-term foreign debt respective to official foreign exchange reserves was high at 204 per cent in June 1997 for Korea, Indonesia (170 per cent) and Thailand (145 per cent).
India is better off on this respect. The short-term debt is about $172 billion, whereas reserves are at over $250 billion. Balanced against this, the East Asians had trade surpluses. Their overseas debt consisted mainly of borrowings to fuel investments in export-oriented manufacturing. India has a primary trade deficit, and a lot of Indian overseas borrowing is for rupee-oriented businesses.
Between June 30, 1997 and December 31, 1997, the Thai Baht fell 48 per cent, the Malaysian Ringgit fell 35 per cent, the Indonesian Rupiah fell 44 per cent, the Filipino Peso fell 34 per cent, and the Korean Won fell 48 per cent. During the same period, in local currency terms, the Thai stock market fell 29 per cent, Malaysia fell 45 per cent, Indonesia fell 45 per cent, the Filipino market fell 34 per cent and the Korean market fell by 50 per cent. When you factor in the currency depreciation as well, the wealth erosion in these nations was massive.
While Indonesia, Thailand and Korea saw GDP contract in 1997, Philippines and Malaysia registered a little GDP growth. In every case, GDP growth was well below pre-crisis forecasts. They all saw capital flight. In 1996, these five nations had net capital inflows of a combined $102 billion. In 1997, that dropped to $0.2 billion. It was minus $ 27.6 billion in 1998. All five nations also suffered domestic banking crises, which was not surprising as debtors defaulted, and liquidity dried up.
Note that the Asian flu victims all had fairly large economies with apparently competent governments. They also had high growth rates prior to the crisis. They tried a mixture of different things to combat the situation.
All these nations raised domestic rates, the Thais panicked and blew their reserves defending the Baht. The Malaysians imposed capital controls. So far, the RBI has tried tightening money supply and it has also sold some US dollars to defend the rupee. It could try other policy measures in the months to come.
India suffered a similar crisis in 1991. The rupee was devalued from Rs 17/$ to Rs 31/$ over the next two years.
GDP growth dropped to 1.3 per cent in 1991-92 before it recovered to move above 5 per cent in 1992-93. Wholesale Price Indices suggest that inflation ran at well over 10 per cent for over two years.
The stock market went insane. Between June 1991 and April 1992, the Sensex rose by over 300 per cent, driven by several scams as well as the promise of liberalisation.
Between April 1992 and April 1993, the market fell by over 55 per cent. This boom-bust is unlikely to occur again. The government is incapable of initiating the big-bang reforms that could set off a boom and there isn't the requisite liquidity in the system.
History never repeats exactly but there is a broad pattern. If this crisis goes by the book, there will be a big currency depreciation, a fall in stock market capitalisation, a cutback in GDP growth rates, net capital outflows and high inflation. A potential banking crisis is also on the cards. It's happened here before, and it's happened in other economies, with similar problems.
None of this sounds pleasant. But there's no point in being an ostrich with head buried in the sand. Investors did make money through these crises. The most successful hoarded cash in the early stages and then bought assets when prices collapsed. This is not a safe strategy. But there is no such thing as a safe strategy in such a situation.