Monkeying with the rupee

  • Blog Post Date 04 September, 2013
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Debraj Ray

New York University

In this article, Debraj Ray discusses the sharp depreciation of the rupee and the ongoing outflow of foreign capital from India. Further, he refutes claims that the costs associated with the Food Security Bill are having a negative impact on the Indian currency.

There´s a story about how to catch a monkey. You use a jar or an empty coconut shell and fill it with peanuts. Monkey approaches, reaches into jar and clenches its greedy little paw around the peanuts. But it can´t pull its full hand out, and what´s more, it won´t let the peanuts go. End of monkey.

How governments in developing countries have wished for similar success when it comes to foreign investment! How India, or Indonesia, or Brazil, or the many countries before them, have hoped that the hard currency could come monkeying in, and then stay, forever enraptured by the goodies that emerging markets have to offer! Alas, it´s never worked that way - or perhaps it temporarily has with foreign direct investment - but certainly never with foreign portfolio investment. What flows in can flow out, and with high probability it will. You can, of course, impede its flow by imposing exit controls but the reputational loss will set you back a generation or more. Foreign capital flow is a two-edged sword, and as India is currently discovering, both edges are very sharp indeed.

What flows in can flow out

The basic economics of this is pretty simple. Imagine a huge stock of hard-currency-denominated investible funds, forever sloshing around in search of the best returns. For a developing country, the urge to tap into these funds is immense. Ideally, that developing country would like those funds to appear as hard, irreversible investment that would soak up its surplus labour, producing goods that would (again ideally) be exported, so earning still more hard currency and incidentally facilitating the repatriation of profits. But that isn´t the way the peanuts are shelled. The hole in the jar needs to be made a lot bigger. Foreign direct investment is often attracted by the enormous internal markets of an India or a Brazil, and the repatriation of that money is not for free, as it were. And much (most?) of the investment will refuse to appear in hard form: why not buy emerging market stocks, or for the not so choosy, emerging market funds, or for the still less choosy, emerging government bonds? Well, why not indeed? And so it was that India started on the Great Upward Path: money pouring into its coffers from abroad, accompanying tariff and quota liberalisation then permitting easy purchase of foreign goods without a huge depreciation in the rupee, the outward drain being more than easily matched by the inward flow.

Quantitative Easing (QE)1 , by keeping interest rates very low in the United States and the rest of the ‘developed world’, certainly helped here, as hot money scrambled to take advantage of relatively attractive portfolios in emerging markets.

But all of this stuff, apart from the hard investment, is reversible - and it has reversed, or is starting to. The monkey´s hand is coming out of the jar, peanuts included.

What caused the reversal of foreign capital flows?

There is little point in asking what fundamentally has changed to cause this reversal. Not much, probably. Yes, QE is probably beginning to taper off, and the US stock market is currently at or near an all-time high. It is time for the hot money to come home2 from its shenanigans in India, Indonesia, Brazil, Turkey and elsewhere.

But even that isn´t a necessary catalyst, because much of the short or medium-return to portfolio investments is prey to severe herding. Consider Scenario 1: money comes into an economy, stock prices climb, the currency stays strong, and rates of return are high. Consider Scenario 2: money flees, the stock market tanks, the currency nosedives, returns fall. Now listen to the one sentence that explains (almost) everything: both Scenarios 1 and 2 can coexist in the same economy with the same fundamentals. Expectations can drive enormous regime changes.

But then, what drives the transition from one regime to another? Often, though not always, the answer is that there is no answer. Or at the very least, there isn´t an answer which in any way can predict this abrupt transition in any deterministic fashion. Markets almost always react long before the fundamentals necessitate those reactions. For instance, a developing-country government might have a large amount of debt denominated in hard currency. Perhaps the citizenry gets too used to the inflow of hard currency and ratchets up its lifestyle, so that the country runs a current account deficit. Or perhaps there is a war or an internal conflict, or a debate regarding economic policy. Perhaps a few Dr Doom types issue a gloomy forecast. All of this is true (to varying degrees) of India. The country may be perfectly solvent nonetheless, but the spectre of possible future insolvency can precipitate a crisis today as the slush money is sucked out. Rome may not have been built in a day, but financial markets are: and what goes up can come down very fast indeed, without any necessary fundamental justification. That´s what herding is all about. Hence, in the short to medium run, there are many exchange rates between the rupee and the dollar that are self-fulfilling equilibria. If someone says that the true exchange rate is 40 rupees to the dollar, or 80 to the dollar, I wouldn´t believe it. Or I would believe it all, just as I believe the rate of close to 70 that it is today.

What does this mean for policy?

We - domestic consumers, producers and government - need to go easy on the upswings. We all get used to good times. The trick is not to act on them fully. We can´t go crazy with imports (gold, oil, machinery, consumer goods), when the spot prices that determine those imports can change overnight, leaving us, perhaps suddenly and without warning, with a large negative flow. And the more reversible the investment is, the more we need to watch it. We need a buffer on this - an action rule or a red line - that is predicated explicitly on the ratio of direct to portfolio investment that´s coming into the country. This is very delicate business, because if we do watch it, then the chances are much higher that investors won´t flee, leading to complaints about why we´re watching it in the first place. As I said, the markets reverse long before the fundamentals fully justify that reversal.

The blame game

It is interesting that the very same business interests which have completely disregarded the dangers discussed above are now floundering around for a scapegoat. There are demands to cut back government spending, and social spending for the masses. Never mind that the foreign-denominated debt of the Indian government is actually relatively small. Never mind that the government is under constant and unrelenting pressure to reduce taxes of all descriptions. Never mind the military expenditures that show that we are a Great and Powerful Nation. Instead, it is the Food Security Bill (FSB)3 that is being blamed4.

The cost of food security

The cost of the FSB is certainly not trivial. As a fraction of the Indian budget (projected expenditure of around 16.6 trillion rupees in 2013-2014), it is about 6%. The point, however, is that it is not a fresh 6%. The Indian government already has a public distribution system (PDS). It has already been procuring massive amounts of food grain not just because of the PDS, because of minimum price supports. In fact, last year we have procured a few tonnes more than is needed for the FSB to run.

But who´s listening? Here´s Forbes magazine on the subject: "[T]the ruling Congress Party barreled ahead with its Food Security Bill in Parliament despite the pervading gloom. The law provides for distributing cheap rice, wheat and other food essentials to the country’s poor but comes at a steep cost of over $20 billion."6

The utter confusion over extra costs versus total costs has been compounded by wrong calculations such as this particularly egregious example, to be credited to Surjit Bhalla7 . His claim is that the FSB will increase expenditures by a whopping 336%. Luckily, this was corrected in no uncertain terms by Ashok Kotwal, Milind Murugkar and Bharat Ramaswami8. They estimate the net additional cost of the FSB to be an increase of approximately 18%: from Rs. 0.72 trillion to Rs. 0.85 trillion. It is an increase of well under 1% of the national budget.

However, this did not stop Moody´s from issuing a threat or two9 . And in the multiple-equilibrium world of herds, it is entirely possible that misinformation can cause an entirely self-fulfilling run on the rupee. Traders taking the Bhalla figures seriously might well flee to safe havens elsewhere. Traders who did not will still fear that other gullible souls might, and seek to front-run them; they too will fly. In this sense, the crashing rupee is to be blamed on the FSB! If it didn´t exist, then Bhalla and others would not have been vilifying it, and we may well have remained in the happy equilibrium of Scenario 1 (above).

Putting food security costs in perspective

The focus on the cost of the FSB masks its simple declaration of basic humanity. Not that the basic humanity itself would go unchallenged. Here is a sample10:

"Why should we continue to feed our people at subsidised costs forever? Why should the country bear this cost ad infinitum?"

There is no accounting for taste but let´s talk about the costs to keep things in perspective.

The defense budget of the Government of India is double the projected expenditures of the FSB. For 2013-2014, a ‘modest increase’ of 5.3% (following on somewhat less modest increases of 17.6% and 11.5% in the two preceding years) brings us to a sum of over 2 trillion rupees.

There´s more: the foreign exchange component of expenditure on defense is orders of magnitude higher than the corresponding component for food. While there has been talk of indigenisation of weapons, India is a huge player in the international market for military equipment and spends around 70% of its current military budget on imports of arms and equipment11. Compare this to the FSB, which will spend half the military budget and all of it on domestic production and distribution. Of course, there are foreign-exchange implications (for instance, exports of cash crops would surely be higher if we let the poor starve). But I assure you that these implications do not come close to the 70% import-intensity of defense.


ut, of course, Defense is a Holy Word.

What about oil, a good measure of the burgeoning needs of India´s middle and upper classes? Just the total cost of subsidising fuel use last financial year was 1.6 trillion rupees12, substantially higher than the estimated expenditure under FSB. (With the Syrian crisis the subsidy could shoot up even further.) As for oil imports, they are in the region of 7 to 8 trillion rupees per year, orders of magnitude higher than projected expenditure under FSB. All in cold, hard currency - but then, Oil is another Holy Word.

Concluding remarks

I will leave the plea for lower defense expenditure or a zero fuel subsidy to a separate occasion. That is not the point of these comparisons. The point is to put things in perspective.

What we have is a bill that purports to bring food security to the majority of India´s population, and possibly the overwhelming majority of India´s poor, plus the additional benefits to mothers and children, for about 6% of the Indian government budget. Not for 12%, as in defense, or 9%, as in the fuel subsidy - and certainly not for the same impact, rupee for rupee, on India´s international deficit.

You know what? I´ll take it.

This article has been adapted with permission from Debraj Ray’s blog at For the full version of the article, see

The author is grateful for comments from Dilip Abreu.


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