When Panic Takes Over

I wonder what exactly went wrong on Friday, August 16 to spook investors in different asset classes so badly. What exactly triggered off a 769-point fall in the Sensex, and a sharp fall in the value of the rupee, taking it below Rs 62 to a dollar? Or what made gold prices shoot up at the same time to over Rs 31,000 per 10 gms? Or what is causing the panic now with the Sensex continuing to drop as if it has a lead bucket attached to its legs, while the rupee has dropped to 64 to a dollar?

As far as I can make out, the economic situation of the country has neither sharply deteriorated, nor improved in the slightest between August 14 and now. Neither the current account deficit nor the overall business environment in the country has become much worse since August 14. So exactly what has spooked the markets – both forex as well as stocks and bonds?

The only thing I can think of is that the twin steps that the government and the central bank took to reduce imports and prop up the rupee on August 12 and August 13 triggered this panic.

On August 12, the government announced that it was increasing the customs duty on gold and silver by 10 per cent in order to curb excessive imports of bullion. The government feels that the import of gold is at least one reason for the worsening current account deficit. The finance minister probably thought that by increasing the import duty on gold, he would be providing a strong disincentive for households to continue buying and hoarding gold. He also probably was under the impression that providing a strong disincentive for import of bullion would not do much harm. Of all the goods and services that India imports, the finance minister thought that gold and silver were probably the least useful. And therefore curbing gold and silver imports would not affect any industry in any significant way, except of course, the jewellery trade.

Meanwhile, the Reserve Bank of India governor was scratching his head about how to stop the rupee from drifting lower every single day. There was always the option of selling some of the dollars that the RBI held in reserves. But the governor assumed that selling dollars to prop up the rupee was not a good idea in the long run. Depleting reserves would make the country too vulnerable. So the governor thought of another way to shore up the rupee – and that was by clamping down on flight of capital. The measures he took included reducing the amount of dollars a company could automatically spend in buying assets abroad – and a similar measure for ordinary citizens as well. He also took steps to tighten short-term liquidity in order to make it more difficult for speculators to spend lots of rupees on buying dollars.

The problem was that all these steps had exactly the opposite effect to what the finance minister and the RBI governor had expected. Instead of discouraging investors from selling rupees and buying dollars, it gave out the signal that the economy was much worse than anyone was letting on. That in turn led to a rush to buy dollars and sell the rupee – or exactly the reverse of what the governor was hoping for. Once the rupee started plunging, the fear invaded the stock markets as well. Meanwhile, the position of the rupee kept worsening. It was 62 on Friday, fell past 63 to a dollar on Monday, and opened at 64 to a dollar on Tuesday, (20th August). And with both the other investment classes plunging, gold suddenly became even more attractive to investors. In fact, the investors assumed that if supplies of gold got cut off, the prices would only go up. And therefore they started buying gold even as the finance minister was hoping that gold demand would taper off.

The problem is that once panic takes over, one never knows how long it will continue. At some point probably the investors will realise that the worries are overblown, and they will start buying again. In which case, the markets will stabilise. But till then, both the rupee and the stock and bond markets will continue to drop.

That takes us back to the next two questions. Has the rupee as well as the stock markets fallen too much? Are they ripe for a rebound?

The answer is probably not, though it could always happen. The issue is that the economy is in a far worse shape than anyone had anticipated at the beginning of the year. The last two IIP numbers have been terrible. Other indicators such as the purchasing managers index have also shown gloomy tidings. There is a threat that one of the rating agencies will downgrade India. Inflation remains volatile, and consumer price inflation shows absolutely no signs of coming under control. Prices of all sorts of goods are going up even while demand is falling. Companies are still struggling with their mountains of debt and corporate growth has slowed. Across the board, profits are under pressure and revenue growth keeps shrinking. Hardly any investment is taking place. After all, who is likely to invest when the conditions remain so volatile and the interest rates so high?

There are a few rupee optimists who feel that the rupee has fallen too far and too fast. But there are plenty of rupee bears who are worried that the rupee will keep dropping to 65 to a dollar, or even further. Some darkly predict that the rupee will not stop falling until it hits 70 to a dollar. At least one person feels that the rupee will fall all the way up to 80 – and in the next few months itself.

In the stock markets too, the view is that the market can fall further. There are no immediate reasons for the stocks to go up. And FII money is not flowing into the stock markets at the moment – and for some time, the FII investment in the stock markets have generally driven the overall sentiment. There are people who feel that stocks will continue falling for a bit more, before they become bargains worth picking up. Others feel that until corporate results show a lot of improvement, the stock markets will remain down in the dumps.

I think that the focus of the government should be on fixing the overall problems in the economy instead of trying to hold up the rupee. Ditto for the RBI.

The rupee will eventually find its own level. At some point, foreign investors will decide that India is a destination worth investing in again. Meanwhile, a dropping rupee will automatically curb a lot of importers of many goods and services. It will also make some industries and sectors in the country more attractive. Already, the IT services industry is expecting better results over the next six months, driven by recovery in the US and a falling rupee. At some point, the CAD situation will also improve and that will help the rupee stabilize, if not strengthen.

Of course, a falling rupee creates many problems. It is a major dampener to any industrialist who is planning to buy machinery or raw materials from abroad. This will further reduce incentives to expand capacities in many industries. Which, in turn, will keep the country’s GDP growth low.

But ultimately, the government has got to realise that it cannot really defend a rupee which is falling because of panic and also because of the economic outlook. What the government and the central bank need to do is focus on the policies that will fix the economy in the medium term – even if there is some pain the short term. And hope that the panic in the markets will get over of its own. There is really little else it can do, at least in the short run.

(The author is the Editor of Businessworld)